seb eastern europe outlook seb_eeo_10_2008

8/14/2019 SEB Eastern Europe Outlook SEB_EEO_10_2008

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Theme: Russia after the elections

ECONOMIC RESEARCH ENGLISH EDITION OCTOBER 2007

Eastern European Outlook

Important your attention is drawn to the statement on the back cover of this report which affects your rights.

OCTOBER 2008

Resilience eroding


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Eastern European Outlook - October 2008

SEB Economic Research

Robert Bergqvist, Chief Economist, [email protected] +46 8 50623016

Hkan Frisn, Head of Economic Research, [email protected] 7638067Mattias Brur, Economist, [email protected] 8506

Susanne Eliasson, Personal Finance Analyst, [email protected] 6588

Bo Enegren, Economist, [email protected] 8594

Ann Enshagen Lavebrink, Research Assistant, [email protected] 8077

Ingela Hemming, Small Business Economist, [email protected] 8297

Mikael Johansson, Economist, Head of CEE, [email protected] 8093

Erik Lindmark, Small Business Analyst, [email protected] 5637

Tomas Lindstrm, Economist, [email protected] 8028

Gunilla Nystrm, Global Head of Personal Finance Economy, [email protected] 6581

Fax no. +46 8 763 9300

SEB, Economic Research, K A3, SE-106 40 STOCKHOLM

Mats Olausson, Chief Strategist, Emerging Markets, TCM +46 8 50623262

[email protected]

Ruta Eier, Economist, SEB Eesti hispank +372 6655578

[email protected]

Andris Vilks, Chief Economist, SEB Latvijas Unibanka +371 7215597

[email protected]

Dainis Gaspuitis, Economist, SEB Latvijas Unibanka +371 [email protected]

Gitanas Nauseda, Chief Economist, SEB Vilnius Bankas +370 5 [email protected]

Vilija Tauraite, Economist, SEB Vilnius Bankas +370 5 [email protected]

Nerijus Udrenas, Economist, SEB Vilnius Bankas +370 5 2682508

[email protected]

Eastern European Outlook is produced twice a year. This report was published on October 8, 2008.It was written by Mikael Johansson (Chief Editor), Ruta Eier, Bo Enegren, Dainis Gaspuitis, Gitanas Nauseda, MatsOlausson, Vilija Tauraite, Nerijus Udrenas och Andris Vilks.

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Eastern European Outlook October 2008

3

Summary

The resilience ofCentral and Eastern Europe in the face of global economic slowdown

is on its way towards eroding. Until now, many countries have maintained their growth

thanks to vibrant domestic economies, with growing investments and consumption. Today,

however, pressure on the regions economies has greatly increased as the euro zone hasstagnated and the repercussions of the international financial and credit market crisis intensi-

fy. We are adjusting our overall growth forecasts downward, and Central and Eastern

Europe can no longer be viewed as a strong growth region. GDP growth in the nine

countries covered inEastern European Outlook will fall from an average of 7.4 per cent

in 2007 to 6.0 per cent this year, 4.5 per cent in 2009 and 4.8 per cent in 2010. Russia and

Poland stand out with continued decent growth but risks are skewed to the downside.

Inflation will fall in most countries, but the downturn will be sluggish in Russia and Slovakia.

Countries with large external imbalances the three Baltic countries and Ukraine are the

most vulnerable to tighter global credit conditions. Credit growth is clearly slowing from a

high level in Ukraine and will fall somewhat further in the Baltics, which are undergoing a

continued adjustment after their overheating.

Russias economic deceleration will be moderate. The reasons are large federal budget and

current account surpluses and the ability to respond to lower demand with a more expansive

fiscal policy. We are also assuming a moderate cool-down in commodity prices. The risk of

major failures in the banking sector is mainly linked to small and medium sized banks.

Ukraines economic outlook has become quickly and noticeably gloomier, after several

years of strong expansion. Overheating problems are not being resolved, due to continued

political instability and deteriorating terms of trade.

In Estonia the recession will be lengthy; GDP will fall again in 2009 and the labour market

will deteriorate noticeably. Home prices will continue to fall, bottoming out only late in 2009.Wage-driven inflation will fall rapidly.

In Latvia, too, the downturn will be long-lasting. Consumption and investments will remain

weak. Unemployment is on the way up, and home prices will continue to fall in 2009. The

countrys large current account deficit will shrink quickly but remain at a high level

Lithuania is beginning a gradual, domestically driven slowdown. Growth will be weak in the

next couple of years. The current account deficit and inflation will remain stuck at high

levels, partly due to the closing of the Ignalina nuclear power plant in 2009.

Poland will experience a soft landing. Underlying economic strength and the modest scale

of the imbalances the country has built up point towards relatively good economic perform-

ance. The governments new target of a transition to the euro by 2011 seems a year too

optimistic. Its ambitions will dominate economic policy, which will be relatively tight. Looking

ahead, this will provide support to the zloty.

Slovakia, the Czech Republic and Hungary will all be relatively hard hit by the euro zone

slowdown; they are more export-dependent than Poland. Growth in Slovakia and the Czech

Republic will halve. Hungary is slowly recovering after its earlier period of tough belt-

tightening policies.


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The international economy

Global recession in 2009

n Synchronised economic slowdown

n Inflation on the way downn Central banks will cut key interest rates

The global financial market crisis continues to have anegative impact on economic performance. Creditconditions have tightened in the wake of major newlosses in the banking system and dramatically widerinterest rate spreads between safe and less safe secu-rities. Although we expect the exaggerated spreadsbetween mortgage bonds and government bonds toshrink after the passage of a giant American financialrescue package, the process of adjustment to a more

normal situation risks being prolonged. It may lastuntil well into next year. A deeper economic slump andcontinued home price declines in the US during thefirst half of 2009, as well as the emergence of bank-ing crises in Europe, will be obstacles along the way.Credit conditions will thus be tough for another while.This will, in turn, hamper the real economy.

GDP growthYear-on-year percentage change

2007 2008 2009 2010

United States 2.0 1.5 -0.3 1.5

China 11.9 10.0 8.0 8.0Euro zone 2.7 1.2 0.3 1.2

United Kingdom 3.1 1.0 -0.5 1.3

Nordic countries 3.0 1.7 1.0 1.8

OECD 2.7 1.3 0.1 1.3

The world 5.0 3.6 2.6 3.2

Sources: OECD, SEB

The world economy will thus lose further momentumafter very high growth in recent years. In 2009,growth in the OECD countries will be lower than in

the early 1990s, because the economic slump isspreading in earnest from the US to Western Europeand Japan. To date, growth has remained good inmuch of Asia and Central and Eastern Europe. Butnow secondary effects from the OECD slowdown arebecoming more widespread while a number of coun-tries are struggling with persistent inflation problems.

Overall, the global economy will grow by 2 per centin 2009, measured in purchasing power-adjustedterms. This is what the International Monetary Fundnowadays defines as a recession at the global level. Aclear recovery in the world economy will take time tomaterialise. Due to credit market problems combinedwith delayed economic policy responses in WesternEurope, growth there will end up well below trend in2010 as well.

For Central and Eastern Europe, the internationaleconomic picture is thus substantially gloomier thanwe foresaw last spring. Compared to Eastern Europe-an Outlookin March, we have adjusted our 2009

growth forecast for the euro zone a vital exportmarket for the countries to its east downward by1.2 percentage points.

Interest rate cuts on a broad frontInflation pressure will diminish as commodity pricescontinue to soften and the increasingly synchronisedeconomic slowdown gradually increases the down-ward pressure on wages and prices. For example,average euro zone inflation will fall from 3.5 per centthis year to 2.3 per cent in 2009. Given our forecast,next summer the year-on-year inflation rate will have

dropped to levels consistent with the European CentralBanks inflation target of just below 2 per cent.

The ECBs concern about inflation will ease due toweaker economic performance. The bank will begincutting its key interest rate during the autumn. It willslash the refi rate from 4.25 per cent to 3.25 per centnext year, followed by further cuts in 2010. Slidinghome prices and paralysed demand in the UnitedKingdom will persuade the Bank of England to cutinterest rates more aggressively. The British repo rateof 5 per cent will be lowered starting in October,reaching 3.5 per cent by summer 2009. The US

Federal Reserve will lower its fed funds rate from 2 to1 per cent in the next six months. If tensions in creditand finance markets should become even more se-vere, joint actions including sharp interest rate cutscannot be ruled out.

We expect long-term government bond yields to showmodest movement in the coming year, although short-term fluctuations may be significant. On the one hand,central banks will be cutting interest rates as inflationfalls, which points towards lower long-term yields.On the other hand, there will be an increased supplyof government bonds due to rising budget deficits,

especially in the US, which will counter a downturn.Looking ahead, the dollar will enjoy support due toexpectations of earlier economic recovery in the USthan in Europe, as well as the resulting earlier interestrate hikes. We expect the EUR/USD exchange rate tostand at 1.30 in a one-two year perspective.

We expect commodity prices to fall somewhat fur-ther, due to ever weaker global economic prospects.For example, we are assuming that oil prices (Brent)will average USD 80-90 per barrel next year.


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Russia

Decent resilience

n Strong but decelerating consumer growth

n Lower commodity prices hampering expansionn Inflation will fall slowly

n Twin surpluses are shrinking

Russia is coping relatively well with internationalcredit market turbulence, but a slowdown in growthis also happening here. Aside from tighter credit con-ditions, other factors behind this deceleration arelower commodity prices and certain capacity con-straints. GDP will grow by 7.0 per cent during 2008as a whole, after last years 8.1 per cent increase.Next year, growth will slow further to 5.6 per cent, in

line with the level usually stated as Russias trendgrowth rate. The risk in the forecast is skewed to thedownside and is associated with more serious effectsof the financial crisis and a larger downturn in com-modities. Fiscal policy will gradually become lessexpansionary, but if the downshift in growth shouldbe larger than we have anticipated, there is both will-ingness and room to ease fiscal policy again.

Growth will continue to be driven by domestic de-mand, while capacity restrictions and real appreciationof the rouble will hold down exports. Russias largefederal budget and current account surpluses will

gradually shrink as oil prices fall to USD 80-90 perbarrel during our forecast period.

Lower commodity prices have contributed to a sharpdecline in the Moscow Stock Exchange since its peaklast summer. Considering that share ownership inRussia is not especially widespread, however, this ishardly likely to have any wealth effects on consump-tion worth mentioning. Financing of companies viathe stock market is not of crucial importance to in-vestments, either. About 50 per cent of corporate

investments are financed via internal cash flows, anindication that the financial sector is still relativelyundeveloped.

Lower commodity prices hurt sentimentTheoretically, the oil price downturn should not makeso much difference to real growth, since variations inoil prices primarily affect federal government savingsin the Stabilisation Fund via extremely high taxation ofoil income. This means that pay and profits are notaffected especially much, as long as the thrust offiscal policy remains unchanged. Despite expenditureincreases in recent years, the federal budget wouldshow a balance even if oil prices fell to USD 60-65per barrel. Yet it is reasonable to assume that futureexpectations of both households and companies areaffected. For example, household saving is likely to behigher if federal government saving decreases. Thiswill curb the appetite for borrowing, at the same timeas lending practices become more restrictive.

The global financial crisis has reached Russia duringthe autumn. The liquidity crisis has developed into acrisis of confidence. The authorities have acted reso-lutely with the support of a large financial buffer.While the crisis may deepen further we believe therisk of major failures in the financial sector seemsrelatively small. Russias banking system is dominatedby a few financially sound banks, several of themwith large state ownership, making it possible to usethe large financial resources of the Russian federationto recapitalise large banks that run into problems.There are also numerous small and medium-sizedbanks that are less well equipped. The credit crisis

will probably accelerate the consolidation of the finan-cial service industry.

Continued slowdown in growthSecond quarter GDP growth was 7.5 per cent, orclearly above trend, yet this represents a downshiftfrom the two preceding quarters, with growth ratesof 9.5 and 8.5 per cent, respectively. As earlier,growth on the output side was mainly driven bydomestically oriented sectors such as distributivetrades, while manufacturing output rose at a moremodest pace. The downward trend in oil output

growth continued, and today output is also falling inabsolute terms. On the demand side, consumption isthe main growth engine, but investments have alsoincreased sharply, although there has been a clearcool-down in recent months. We expect consumptionto remain the most important driving force behinddemand, among other things supported by continuedgood real wage increases and some support, albeitfading, from fiscal policy. The new middle class willcontinue to be an economic engine, through greaterconsumption but especially as a producer of variousnew services.

Large-scale federal spending on infrastructure willsustain investments in the next few years. Meanwhilewe expect certain negative effects from the tightercredit situation on private capital spending. Another

Year-on-year percentage change

Russia: GDP and inflation

GDP (LHS) CPI (RHS)Sources: Rosstat, SEB

02 03 04 05 06 07 08 09 10

0

2

4

6

8

10

12

14

16

01

2

3

4

5

6

7

8

9

SEB forecast


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Russia

constraint, especially in the construction sector, ishigh capacity utilisation. New housing starts, forexample, are rising at a substantially slower pace thanbefore, indicating a deceleration in residential con-

struction. Although large investment projects maycontribute to increased overheating problems in theshort term, boosting the investment level is vital togrowth in a somewhat longer perspective, especiallyin light of Russias negative demographic trend.

The trend towards stagnating or slightly falling oiloutput will probably continue. Many oil fields arenearing depletion, while few have been added in re-cent years. Insufficient investments are one reasonfor this, which in turn may be partly related to unclear

rules of the game for foreign companies and uncer-tainty about the role of Russias government. Anotherreason is the high tax burden. However, oil sectortaxation is currently being re-assessed, includingproposals for tax exemption during the first year ofoffshore production. New legislation on strategicsectors, including gas and oil, has removed some ofthe uncertainties about the rules for foreign compa-nies. The government has also recently boosted itsappropriations for prospecting, but ensuring produc-tion growth in the medium term will require giganticinvestments, since new discoveries are often locatedfar from developed infrastructure. It is also worth

observing that while Russia is indeed the worldssecond largest oil producer after Saudi Arabia, thecountrys known oil reserves are only the seventhlargest in the world.

Since growth in oil and gas output is so weak, thiswill eventually squeeze export income, especially withprices now on their way down. Oil and gas accountfor more than 60 per cent of the countrys exportincome, about 20 per cent of GDP and 45 per cent offederal government revenue. The easiest way forRussia to increase, or rather maintain, its level ofenergy exports is to reduce its high domestic energy

use. This is also the purpose of the ongoing deregula-tion of the energy sector and plans for market adjust-ment of gas prices for domestic users by 2011.

High underlying price pressuresDespite some deceleration in recent quarters, theeconomy is still growing above potential. Among theresults are higher resource utilisation and a largerproportion of demand being satisfied via increasedimports. Various types of bottleneck problems havebecome increasingly apparent. In places, labour short-ages are also an obstacle to expansion, especially inMoscow and St. Petersburg, where unemployment isclose to zero. Due to relatively low geographic mobili-ty, competition for labour in these areas is driving uppay, which is currently increasing at about 30 per centannually. Real wage growth has been substantiallyhigher than productivity for several years. Due in partto higher resource utilisation, underlying inflation hasmoved upward in the past year, but the most impor-tant reason for the doubling of CPI inflation sinceearly 2007 is sharp food price increases. Since foodaccounts for 40 per cent of the consumption basket,these hikes have had a strong impact on CPI.

Since last spring, the inflation rate has been relativelysteady at around 15 per cent. We expect a slightdecline via lower contributions from food and energy,but judging from producer price trends, for example,the downturn is likely to be moderate in the shortterm. Looking somewhat further ahead, lower interna-tional prices and probably also reduced inflows of

foreign capital will help ease price pressure. Workingin the opposite direction will be various planned hikesin prices and fees over the next few years, for exam-ple gas and electricity. Overall, we expect inflation toaverage slightly below 14 per cent this year and fall toslightly more than 11 per cent next year.

Direction of rouble less obviousThe central bank has repeatedly failed to achieve itsinflation target. One reason is that the bank has simul-taneously had an exchange rate target. The primaryreason behind this target is that Russia wants to avoid

excessively rapid appreciation of the rouble, whichjeopardises businesses outside the commodities sectorthat are exposed to international competition. In recent

Year-on-year percentage change USD/barrel

Russia: Oil output and prices

Oil output (LHS) Oil price, Ural (RHS)Sources: Federal State Statistics Service, Reuters EcoWin

01 02 03 04 05 06 07 08

-2.5

0.0

2.5

5.0

7.5

10.0

12.5

15.0

10

30

50

70

90

110

130

Year-on-year percentage

Russia: Pay, CPI, and M2 money supply

M2 (LHS)Wages and salaries (RHS)

CPI (RHS)

Sources: Federal State Statistics Service, The Central Bank

04 05 06 07 08

5.0

10.0

15.0

20.0

25.0

30.0

1015

20

25

30

35

40

45

50

55

60


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Russia

years, the central bank has allowed nominal apprecia-tion averaging about two per cent annually against abasket consisting of 55 per cent dollars and 45 percent euros. This reflects the trend against the dollar,

while the rouble has weakened against the euro. Sincemore than 60 per cent of imports come from the EUand only 3 per cent from the US, this has helped todrive up import prices.

During the spring and summer, the central bankmoved cautiously to tighten monetary policy, mainlyby boosting reserve requirements. The banks mostimportant interest rate has remained sharply negativein real terms. In the spring, the bank announced plansto allow larger rouble exchange rate movements tomake it harder to foresee short-term fluctuations andthereby counter speculative capital inflows. The goal

is that starting in 2011, monetary policy will be man-aged only on the basis of an inflation target. Untilthen, the central bank will continue to base its ex-change rate policy on a dollar/rouble basket.

The external conditions for central bank policieschanged drastically when the credit crisis reachedRussia in earnest late in the summer. Capital inflowswere replaced by outflows due to falling commodityprices, increased political uncertainty and generalglobal credit market turmoil. The situation was exac-erbated in part by large tax payments and the need torefinance relatively large foreign loans during the

autumn. The strategy of Russian authorities for at-tacking the credit crisis was to furnish the largebanks, which are pivotal to the financial system, withliquidity. In addition, all banks received support via alowering of reserve requirements. The ministry offinance also undertook stepped up oil surplus auc-tions. Among other measures being undertaken arelower taxation of oil exports, a more flexible VATpayment system, higher government bank depositguarantee limits as well as earmarking of funds forpossible repurchase programmes in state-ownedcompanies. Despite official auctions, small and medi-um-sized banks are still in a very strained situation.

The rouble weakened by more than 3 per cent inAugust and September but then recovered marginally.Even if the rouble recovers some lost ground ahead,appreciation pressure will probably fade gradually asRussias current account surplus falls. Our assess-ment is that the rouble will then again weaken.

Increased political riskThe presidential transition last spring was just asundramatic as one could expect. Two thirds of PrimeMinister Vladimir Putins government, which wasunveiled in mid-May, consists of members of theprevious government. The remaining members aremainly people that Putin brought with him from hisown presidential administration. As earlier, the govern-

ment is a mix of liberals and tougher individuals, but itseems as if the liberal wing has been strengthenedsomewhat. President Dmitry Medvedev has also beenperceived as relatively liberal and business-friendly,

due to his clear focus on reducing corruption andbureaucracy and strengthening the rule of law, but anumber of events during the summer fuelled uncer-tainty about government policy. The escalation of theconflict between BP and its Russian partners in thejointly owned company BP-TNK again focused atten-tion on conditions governing foreign companies.Putins criticism of pricing policies by the Mechel coaland steel company led to strong reactions in the stockmarket. The military conflict in Georgia further dam-aged investors faith in the predictability of Russianpolicies. Strong market reactions to the summersevents probably came as a surprise to the government

and may have served as an alarm clock, which in turnmight lead to improvements in the investment climate.

Whos in charge?Various contradictory statements by the president andprime minister related to the Georgia conflict havealso fuelled speculation about the division of powerbetween Putin and Medvedev. The combination of apresident with strong formal powers and a primeminister with significantly less formal power but verystrong informal power by virtue of his dominantpersonality implies uncertainty as to where real power

lies. According to public opinion surveys, a clearmajority of the Russian public believes that Putin isstill in charge. So far, there have been no externalsigns of a split between the two. However, it remainsunclear whether Putin sees his role as gradually ced-ing power to Medvedev while the latter builds up hisown power base, or whether Putin is planning acomeback as president by winning the 2012 presiden-tial election.

As for the consequences of increased tensions withthe West and the Georgian conflict, they may furtherdelay future World Trade Organisation membership.

However, due to ever-increasing mutual dependencebetween Russia and the EU in economic, financial andenergy-related terms, there are major incentives onboth sides to limit tensions. The powerful reactions toRussias foreign policy actions, especially in financialterms, also serve as a moderating factor, since thecountrys political leaders are not unaffected by thedissatisfaction of various economic interests withthese developments.


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Ukraine

Gloomier outlook

n Decelerating credit growth weaker domestic

demandn Record-high inflation will slow but will

remain in double digits

n Less favourable terms of trade will lead to

larger current account deficits

After several years of vigorous expansion in theUkrainian economy, the growth outlook is now deteri-orating. There will, of course, be continued strongpotential for catch-up-driven growth and for greaterintegration in the world economy. Meanwhile, howev-er, the countrys overheating problems have intensi-

fied, as manifested in its rising current account sur-pluses and record-high inflation. Recurrent govern-ment crises have led to the postponement of importantstructural issues, and fiscal policy has become in-creasingly pro-cyclical. Ukraines deteriorating exter-nal balance and greater private debt abroad is increas-ing the countrys vulnerability in the shadow of theglobal credit crisis.

Ukraine now faces an adjustment to a more sustaina-ble economic trend. Due to weaker credit growthahead, domestic demand will decelerate, while exportswill be hampered by weaker competitiveness and

deteriorating international economic conditions. GDPgrowth will fall from 6.3 per cent this year to 3 percent in 2009 and then recover somewhat to 4 percent in 2010.

In recent months, growth has become increasinglyimbalanced, including slowdowns in exports andinvestments as well as in consumption, which ac-counts for an ever-larger proportion of demand.Meanwhile import growth has accelerated, partly a

reflection of weaker competitiveness, despite the factthat the hryvnina has largely followed the weakeningdollar in recent years. Although there will be a slightrebound due to a bountiful agricultural harvest, ex-

ports will once again be squeezed as demand weakensfurther in major customer countries in Europe. Weak-er production will also have an impact due to a dimin-ished need to expand capacity, which will restrain

capital spending. Increasingly tough lending practiceswill have a similar effect ahead. There has alreadybeen a clear deceleration in construction due to thehousing market slowdown, and this trend will intensi-fy in the coming year.

There has been a noticeable deceleration in creditgrowth from a rate of nearly 80 per cent early thisyear to less than 60 per cent in recent months. Thistrend will be accentuated as banks become morecautious about their lending, in the wake of the globalcredit crisis. The Ukrainian consumption boom willthus lose momentum and slow to more sustainable

levels.

Due to the slowdown in domestic demand, extremelyexcessive growth in imports will gradually decelerate.This does not imply any improvement in the tradebalance, however, since we meanwhile expect a cleardeterioration in Ukraines terms of trade. After therecent very favourable trend, especially for steelprices, we expect a slowdown ahead, in line withother commodity prices. Meanwhile import prices willclimb when Russia boosts natural gas prices at the

beginning of 2009. According to widely circulatedinformation, these prices will more than double. Thefinal outcome will be a matter of negotiations, and it ispossible that Ukraine may escape with a smaller pricehike. To some extent, it can offset price hikes byraising transit fees. If the increases should amount to100 per cent, this means that the value of importswould increase by about 5 per cent of GDP in 2009.Although the price hikes may be lower, we are ex-pecting a current account deficit of 7.5 per cent ofGDP this year and 10 percent in 2009.

Despite its poorer current account outlook and the

uncertain situation in global finance markets, Ukraineattracted large capital inflows during the first half.Among other things, foreign direct investments roseby 40 per cent compared to the same period of 2007.

USD billions

Ukraine: Current account balance

Source: National Bank of Ukraine

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

-4

-3

-2

-1

0

1

2

3

-4

-3

-2

-1

0

1

2

3

Ukraine: Stock market and CDS price

PFTS (LHS)5-year credit default swaps, CDS (RHS)

Source: Reuters EcoWin

Jan

07

Apr Jul Oct Jan

08

Apr Jul Oct0

100

200

300

400

500

600

700

800

900

1000

300

400500

600

700

800

900

1000

1100

1200

1300


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Ukraine

Given the recent sharp deterioration in risk appetite,however, this favourable trend is rather unlikely tocontinue. FDI inflows are also being hampered be-cause the government has postponed privatisation

plans for the time being. With foreign debt havinggrown relatively quickly, from about 45 per cent ofGDP in 2005 to 60 per cent last year, financing re-quirements will increase in the future.

Inflation culminated in May at above 31 per cent butslowed to 26 per cent in August. Considering thatfood makes up half the CPI consumption basket,inflation in Ukraine has been greatly influenced by thefood price trend. Meanwhile there is strong underlyinginflation pressure in the economy, with wages andsalaries rising about 35-40 per cent. In addition, fiscalpolicy has been clearly pro-cyclical, among other

things via sharply higher transfer payments. Lookingahead, we expect inflation pressure to continue easinggradually. Reduced price pressure from food andgradually slower pay increases as the economy decel-erates will contribute to this. Meanwhile there is apent-up need to raise various charges and fees. Thesharp price increases for gas are another reason whythe downturn will occur gradually. Our assessment isthat inflation will average nearly 26 per cent this yearand fall to 16 per cent in 2009.

The National Bank of Ukraine has relatively limitedmeans for combating inflation, since monetary policy

focuses chiefly on maintaining a fixed exchange rateagainst the dollar. Since last summer, the bank hasaimed at keeping the hryvnia in the UAH 4.65-5.05range against the dollar, with a benchmark rate of4.85. The central bank has also signalled that it willgradually shift towards maintaining an exchange rateagainst a basket of currencies. At first the hryvniatraded in the stronger portion of its band, very muchdue to continued strong capital inflows, but during theturbulence of recent weeks, the rate has weakenedclearly. Our assessment is that the hryvnia will weak-en further against the dollar as a consequence ofrising current account deficits and reduced capital

inflows. By the end of 2009, the exchange rate againstthe dollar will be 6.50.

Politics getting even messierThere have been recurrent political crises in recentmonths. In June, two defections from coalition partiescaused the government to lose its parliamentary ma-jority, but a later court ruling declared these defectionsunconstitutional. Meanwhile the conflicts betweenParliament and President Viktor Yushchhenko onconstitutional reform have escalated. When PrimeMinister Yulia Timoshenko joined forces with the

opposition in order to curb presidential power, Yush-chenkos party Our Ukraine pulled out of the govern-ment. A snap election is thus moving ever closer, onlya year after the last one. It would be the third parlia-

mentary election in as many years. Judging frompublic opinion surveys, the Timoshenko Block wouldmake major gains in a possible early election. Supportfor Yushchenko and Our Ukraine has collapsed and is

now only about 5-6 per cent. Weak public support forthe President and Our Ukraine indicates that the partyhas very little to gain from a snap election and mightthus be willing to conclude a new agreement with theTimoshenko Block.

Another conceivable solution to the crisis is for theTimoshenko Block to form a broad coalition with thepro-Russian Party of Regions. Timoshenkos lowprofile during the Georgia conflict and improvedrelations with Russia have undoubtedly made it easierfor such a constellation to take shape. Regardless ofhow the current crisis ends, however, the potential for

a strong government will not be especially good untilthe presidential election early in 2010, since the issueof the division of power between the president andparliament remains unresolved. Added to this domesticpolitical turbulence is greater uncertainty in relationswith Russia, triggered by the crisis in Georgia. Al-though the parallels between the break-away regionsof Georgia and the situation in the Crimea are mislead-ing in many respects, increased tension in the regionis a further uncertainty factor.

It is not obvious what the economic consequences ofthis uncertain political situation may be. Instability in

Ukrainian domestic politics is nothing new, althoughthe situation has deteriorated in recent months. Yeteconomic growth has remained strong and foreigninvestments have continued to flow into the country.One possible reason is that despite Ukraines messypolitics, there is relatively broad consensus about suchfundamental matters of policy as closer relations withthe EU, WTO membership (Ukraine became a mem-ber this year) and key elements of reform policy.However, there is now a risk that politics will have amore negative impact on the economy ahead. Due todomestic political disunity, fiscal policy has becomeincreasingly pro-cyclical, thereby worsening the

overheating in the economy. A continuation of theconstitutional conflict on the division of power be-tween Parliament and president will also be a growingobstacle to the implementation of important reforms.


10/2510


Estonia

Lengthy recession ahead

n Home prices are continuing to fall

n Domestic demand remains depressedn Inflation will rapidly come down

Since the second quarter of 2008, Estonia has slid intorecession. There seems to be relatively little chance ofavoiding a lengthy period of negative growth. In 2009,global financial and economic stress will leave itsmark on Estonia. In addition to obvious pressure onexports, an equally crucial effect will be via monetaryconditions, which will tighten. Domestically, theadjustment has been slower than expected, withremarkable inertia in the labour market and prices.Next year, the government will also boost several VATrates. That means that the correction will take longerthan previously thought and major shifts are expectedto happen only in 2009, further prolonging the reces-sion. In 2009, negative GDP growth will continue,averaging minus 2.2 per cent. In 2010, growth willrecover to plus 2 per cent.

A lengthy recession combined with marked losses ofcompetitiveness implies a risk of currency adjustment.In our new, darker economic scenario, with a moresubstantial increase in unemployment this risk hasrisen despite the governments tightening measures.

Weaker prospects for exports imply that the return tosustainable current account deficit (5-7 per cent ofGDP) will take a longer time. But our main scenario isstill that Estonias exchange rate peg will survive. Asubstantial share of loans in the private sector isdenominated in euro. Therefore the costs associatedwith a devaluation are large. Consequently we expectthat the authorities will go very far in order to pre-serve the currency pegs. The same argument goes forLithuania and Latvia.

The economic slowdown started with a gradual defla-tion of the real estate bubble from mid-2007 onward.

A year later, the average price of flats had fallen 15per cent, and in Tallinn 19 per cent.

Early in 2008, several additional external shocks hitthe economy, including skyrocketing oil prices anddecelerating global growth, while transit trade fell 40per cent below the year-earlier level. These develop-

ments finally drove Estonia into recession. As a con-sequence of additional shocks, by mid-2008 the eco-nomic downturn had become very widespread, af-fecting not only domestic demand but also such keyexport sectors as wood, furniture and textiles.

Meanwhile other export sectors like metals, chemicalsand machinery production were performing quitewell. Even in construction, value-added remainedpositive, despite the freezing of several constructionprojects in 2008 due to oversupply in the real estatemarket. Construction was sustained by public sectorand commercial property projects, which will not be

there any more in 2009.

Because so many projects were being built, as ofmid-2008 no decrease of employment in the construc-tion sector had occurred. In June, overall unemploy-ment stood at an all time low, 4 per cent. However,vacancies have been declining since late 2007. A risein the jobless rate is expected during the second halfas the manufacturing sector shrinks. Wage growthslowed from 19 per cent year-on-year in the firstquarter of 2008 to 15 per cent in the second quarterand should moderate to an average of about 8 per centin 2009. Jobs will also disappear in the public sector

during the second half of 2008 due to expenditurecuts. This means that unemployment will increase notonly in the blue-collar segment but also the white-collar segment. Unemployment will not climb sharply,however, since the labour market remains rather tightand some of the people who are laid off can be em-ployed in other sectors.

The longer the recession lasts, the more likely it is thatsome companies will not survive the pressure. Thissituation will culminate in 2009, whereas in 2008 mostcompanies can still rely on savings and other assetsaccumulated during previous boom periods.

Tighter credit conditionsThe global credit crunch will mean less capital inflowand higher interest rates. The massive expansion ofcheap creditthat fuelled the rapid growth of recentyears will be replaced by very cautious lending prac-tices and higher interest margins. Tighter credit sup-ply will constrain real estate and other investmentsand favour companies in good financial health.

Home prices will continue downward in 2009 asfinancing conditions remain tight, consumer confi-dence is low and the real estate oversupply persists.

We expect residential investments to decline in 2009.The fall in real estate prices will help prolong theeconomic slump. We expect prices of flats to bottomout at 25 per cent below their peak late in 2009.

EEK per square metre, year-on-year % change

Estonia: Property prices

Tallinn, price (LHS)Estonia, price (LHS)Tallinn, change (RHS)Estonia, change (RHS)

Source: Estonian Land Board

Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1

03 04 05 06 07 08

-30

-10

10

30

50

70

0

5000

10000

15000

20000

25000

30000


11/2511


Estonia

Non-residential property investments will also remainbelow trend, reflecting tighter credit conditions andlow confidence. In 2008, profits were hurt by rapidlyincreasing input costs and decelerating sales. In 2009,

sales will still be depressed, but input costs will fall asa looser labour market slows wage growth. Oil priceswill have peaked in 2008.

Falling prices of homes and other assets will reducehousehold wealth and keep down consumption. De-spite rapid wage growth deceleration, the pace of realpersonal income growth should remain positive,though modest, since inflation will also fall at a rapidpace. However, consumption will slow due to deterio-rating confidence and higher unemployment.

With domestic demand suppressed and wage inflation

slowing markedly, there will be far less inflation pres-sure ahead. Estonias major indirect tax hikes tookplace in 2008, setting the stage for lower inflation, butthe governments latest budget bill proposes VATincreases on such items as medicines, books andconcert tickets. Also, electricity prices will increase.Import price increases have peaked, and lower oilprices, the inflation rate will slow to 5.0 per cent in2009 and 3.5 per cent in 2010.

The government is continuing to aim at a balancedbudget and will therefore cut various planned expendi-tures in the next few years. It plans to freeze publicsector pay, trim operational expenses and cancelcertain investments, especially property-related ones.Despite a much slower increase in government spend-ing in 2009 than previously, tax revenue is likely to beinsufficient to meet expenses. We thus expect a defi-cit.

Exports crucial for recoveryDuring 2009, the only way Estonia can climb out ofits recession will be through exports, and the funda-mental question here is competitiveness. Due to rapid-ly decelerating external demand, export growth hadalready shrunk to almost zero by mid-2008, and weexpect a further slump. This decline might be coun-

teracted by an increased willingness to export. During2006-2007, some companies focused on the domesticmarket, profiting from rapid price increases and theconsumption boom. This was one reason why export

growth rates fell earlier than foreign demand.

Meanwhile high domestic price increases and appreci-ation of the currency (the real effective exchange rateclimbed) undermined competitiveness, and productivi-ty growth lagged. Over the next few years, one maintask for exporters will be to bring their productivitygrowth back in line with wage growth. Reducing thelabour force will be one part of this process.

Fading inflation pressure will help lay the groundworkfor economic recovery in 2009 but will probably benot sufficient to counteract diminishing external de-mand. Another growth-supporting factor will beservice exports. Although the global slowdown willlower the demand for services, they are less cyclical.

Estonia: Growth in export markets and exports

Weighted average, growth in main export markets (LHS)Estonian export growth (RHS)

Sources: Reuters EcoWin, SEB

96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

-20

-10

0

10

20

30

40

50

60

1

2

3

4

5

6

7

8

SEB forecast

Index 2000=100

The Baltics: Real effective exchange rate

Latvia Estonia LithuaniaSource: BIS

00 01 02 03 04 05 06 07 08

85

90

95

100

105

110

115

120

125

130

135

85

90

95

100

105

110

115

120

125

130

135


12/2512


Latvia

Recession ahead

n Plummeting demand will help dampen

imbalancesn Tighter fiscal policy but export stimulus

n Weak real wage growth in 2009

After three years of double-digit GDP increases,leading to an overheated economy, Latvia is nowexperiencing a slump in domestic demand. Growthhas almost vanished. This is partly connected totighter credit conditions and global financial turmoil.Negative GDP growth is a certainty during the nextseveral quarters. Stagnating demand in the euro zoneand troubled world financial markets will have a

dampening effect on Latvias economic recovery.Furthermore, fiscal policy will be tightened. We havethus substantially revised our previous GDP forecastdownward to minus 0.5 per cent this year, minus 2.0per cent in 2009 and expect plus 2 per cent in 2010.The sharply cooling economy will help dampen thecountrys long lasting imbalances. The large currentaccount deficit will continue to shrink relatively quick-ly. Inflation will wane substantially due to the reces-sion.

Looking ahead, due to global financial turmoil theLatvian economy, with its elevated foreign debt, willface tightening financing, which may lead to specula-tion about the stability of the currency. Despite acontinued decline in external imbalances, we see alingering exchange rate risk. In our new recessionscenario this risk has increased, although we stillassume that Latvia and the other two Baltic countrieswill maintain their exchange rate pegs. The risk of anexchange rate adjustment (devaluation or freely float-ing currency) seems greatest in Latvia, followed byEstonia.

The growth rate plummeted from stable double-digitfigures to almost zero in the second quarter of 2008.Both private consumption and investments declined,

and the economy was mainly driven by exports. Forthe fifth consecutive quarter, there was clear down-ward trend in manufacturing and retailing. Supportfrom construction, transit trade and commercial

services was also weaker than expected.

The governments plan to cool the economy, present-ed in the spring 2007 after a period of currency tur-moil, proved ineffective. It was implemented veryselectively and with long delays. One important goalof this anti-inflation plan was to bring down unsus-tainably high private sector credit growth. Meanwhilesuch external factors as rising energy and food pricesand the global credit crunch increased the risk of a

hard landing. Economic sentiment indicators droppedto levels not seen since the early 1990s. In 2007, thereal estate bubble burst. Home prices have fallen 35per cent from their peak. We expect a further 20 percent correction by 2009 before the market stabilises.

Surprisingly, todays sluggish growth has not yet beenreflected in the labour market. On the contrary, in thesecond quarter job growth continued. Unemploymentfell to 6.3 per cent, mainly due to more active job-

seeking in anticipation of the coming recession. How-ever, a sharply decreasing number of vacancies andexpected workforce reductions in both the private and


Latvia: GDP and inflation

GDP (LHS) Inflation (RHS)Sources: Statistics Latvia, SEB

01 02 03 04 05 06 07 08 09 100

2

4

6

8

10

12

14

16

-2

0

2

4

6

8

10

12SEB

forecast

Per cent of GDP

Foreign debt

Latvia EstoniaSource: Reuters EcoWin

00 01 02 03 04 05 06 07 08

40

50

60

70

80

90

100

110

120

130

140

40

50

60

70

80

90

100

110

120

130

140

Exchange rate EUR/LVL

Source: Reuters EcoWin

05 06 07 08

0.6925

0.6950

0.6975

0.7000

0.7025

0.7050

0.7075

0.7100

0.7125

0.6925

0.6950

0.6975

0.7000

0.7025

0.7050

0.7075

0.7100

0.71250,7100

0,6960

0,7028 1%


13/2513


Latvia

public sector will push unemployment up to 9 percent next year.

Nominal wage and salary growth slowed to 24 per

cent in the second quarter from above 30 per cent asrecently as the fourth quarter of 2007. This decelera-tion can partly be explained by intensive efforts lastyear to legalise wages and salaries in the informaleconomy. Pay increased have slowed both in theprivate and the public sector. We expect nominal wagegrowth to decline to 9 per cent next year, resulting innegligible real wage growth.

Inflation slowing

Inflation peaked in May at a 17.9 per cent rate due tounprecedented hikes in regulated prices and commodi-ty prices but started to lose momentum in the sum-mer, partly due to a substantially drop in consumption.In August, consumer prices rose 15.7 per cent year-on-year. Despite this autumns 40 per cent hike innatural gas prices, inflation will decrease to 13 percent by year-end. Absent further energy price and taxhikes in 2009 and because of constrained consump-tion, it will fall to single digits next spring. We expectinflation to average 16.1 per cent in 2008, 8 per centin 2009 and 5 per cent in 2010. The latter is neverthe-less nearly twice the rate that Latvia would need to

show in order to meet the inflation criterion for joiningthe euro zone, so euro adoption is still far away.

In line with our expectations, the current accountdeficit has decreased. During the first half of 2008, itwas 16.9 per cent of GDP, compared to 25 per cent ayear earlier. The main factor was a shrinking foreigntrade deficit, due to good export performance andlower imports. In addition, Latvia recorded a morepositive service balance.

Weak domestic demand will lead to a further decreasein the current account deficit to 10 per cent of GDP in2009. However, financial and economic challenges inLatvias main export markets will blunt further export

growth. Foreign direct investments into Latvia re-mained stable in the first half of 2008. Four fifths ofthe second quarter current account deficit was cov-ered by long term capital, of which 58 per cent was

FDI.

The budget will be tightenedOverly optimistic budget planning forced the govern-ment to abandon its goal of achieving a public budgetsurplus of 1 per cent of GDP in 2008. Prime MinisterIvars Godmanis, who has extensive experience fromthe tough reforms of the early 1990s, is playing a keyrole in efforts to tighten spending in 2009. To ensurethat the budget deficit is as small as possible, he iscalling for such measures as a pay freeze in the publicsector and a reduction in the number of public em-

ployees.

During the summer the government tried to force allstate institutions to cut their planned costs. However,these plans had to be shelved. The current budgetproposal for 2009 projects a deficit of 1.85 per centof GDP and will be decided by Parliament in October.The major labour unions are upset with the proposedfreeze on public sector salaries, and passage of thebudget will depend on trade-offs between the unionsand the Godmanis cabinet. The prime minister isdetermined to cut the number of public employees by10 per cent in 2008-2009. Despite these severe cost

cutting measures, the government is unlikely to es-cape fiscal deficits this year and next. Our forecast isthat the deficit may reach 1.5 per cent in 2008 and 3per cent in 2009, thus touching but not exceeding theMaastricht Treaty limit.

The government is under pressure from the businesscommunity and voters in general to soften the impactof the approaching recession and stimulate purchasingpower. Since the spring, the government has takensteps to improve Latvias competitiveness in 2009.This has included increasing the availability of exportguarantees, allowing faster depreciation of assets,

exempting investments in new technologies fromprofit taxes, reducing bureaucracy and speeding upthe utilisation of EU funds. The authorities have re-sponded to the demands of commercial banks bybroadening liquidity in the financial market and bylowering reserve requirements.

Latvia: Consumer confidence and retail sales

Consumer confidence, net balance (LHS)Retail sales, year-on-year percentage change (RHS)

Sources: DG ECFIN, Statistics Latvia

02 03 04 05 06 07 08

-40

-30

-20

-10

0

10

20

30

40

-35

-30

-25

-20

-15

-10

-5

0

5


14/2514


Lithuania

Soft landing so far

n Growth is gradually slowing down

n No major easing of inflationn Outcome of parliamentary elections uncertain

GDP grew by 5.2 per cent year-on-year in the secondquarter of 2008. This was slower than in the firstquarter, when GDP grew by 7 per cent. The slow-down will be more apparent in the second half of theyear. Our latest forecast of 5.5 per cent GDP growthfor 2008 as a whole is still realistic. In 2009 downsidepressure will be stronger, given weakening sentimentin domestically oriented sectors such as construction,retail trade and transport. Moreover, sectors relying

on exports are also facing uncertainty, since Lithua-nias main export markets are stagnating. We expectthe country to avoid a technical recession, but GDPgrowth will be weak: 2 per cent in 2009 and 1 percent in 2010. Our forecasts have been cut.

Domestic demand will dampen further in the wake ofdeteriorating consumer sentiment, tighter lendingconditions and an inflation spike due to rising centralheating charges. In the second quarter, retail growthslowed markedly, and consumer sentiment worsenedsharply in the summer months. January-August 2008

retail sales grew by 10.1 per cent year-on-year, fol-lowing first quarter growth of 29.4 per cent. Thedomestic market is cooling due to stagnating realestate and construction sectors (especially the resi-dential segment). This will dampen related activitiessuch as production and sale of construction materials,furniture and domestic appliances. Ober Haus RealEstate research notes that prices of residential proper-ties fell roughly 10 per cent in the first half of 2008.Overall 2008 prices could fall by 15 per cent, and in2009 by a further 10 percent.

While domestic demand is slowing, exports are still

holding up so far. Downside risks are increasing,however. During January-July 2008, exports in-creased by 33.8 per cent. However, the slowdown inthe euro zone economies, as well as the repercussions

of the global credit crunch, will reduce the appetitefor Lithuanian goods. CIS exports remain strong(Russia absorbed 15.1 per cent of Lithuanian exportsin January-July), due to lower inflation in Lithuania

and strong economic growth in these markets. In-creased political risk in Eastern markets has not trans-lated into actions limiting purchases of Lithuanianexports.

Lithuania exceeded its tax collection target for the firsthalf of the year, but a gap emerged as early as July. Itwill widen further by the end of the year as decelerat-ing retail sales limit value-added tax revenue. Moreo-ver, the profitability of enterprises is set to decline and

corporate tax inflow might shrink correspondingly.Given the election cycle, public expenditure cuts willbe limited in scope. Moreover, recent law on theindexation of minimum wages, pensions and socialbenefits as well as agreed pay increases in the healthand education sectors will sustain pressure on publicexpenditures. Although the fiscal discipline law pre-scribes only a 0.5 percent deficit for 2009, we areraising our fiscal deficit forecast to 1.5 per cent ofGDP this year and next.

Wage and salary growth coming down

Nominal wages and salaries continue to grow fast,although real wage growth is slowing down. Duringthe second quarter of 2008, average gross wagegrowth remained robust at 22.5 per cent year-on-year.Public sector wages were supported by decisions thattook effect from January 1, 2008 a minimummonthly wage increase, an increase in base earnings,and a lower personal income tax rate. During thesame quarter, additional wage increases took effect inthe health and education sectors, and further increasesare scheduled in the third quarter.

Total gross wage and salary growth should slow to 15

per cent during the fourth quarter due to economicdeceleration, statistical base effects and higher unem-ployment. Public sector wage growth in 2009 will becontained due to an expected deterioration in tax


Lithuania: GDP and inflation

GDP (LHS) Inflation (RHS)Sources: Statistics Lithuania, Eurostat, SEB

00 01 02 03 04 05 06 07 08 09 10

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

0

1

2

3

4

5

6

7

8

9

10

11SEB forecast

Year-on-year percentage change, constant price

Lithuania: Domestic demand and exports

Domestic demand ExportsSources: Statistics Lithuania, SEB

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2

06 07 08

0.0

2.5

5.0

7.5

10.0

12.5

15.0

17.5

20.0

0.0

2.5

5.0

7.5

10.0

12.5

15.0

17.5

20.0


15/2515


Lithuania

collection by the end of the year. Total gross wagegrowth in 2009 will still reach 13 per cent.

Inflation will remain highDuring the summer, the inflation rate began a slightretreat. The easing of food and energy prices in globalmarkets should significantly dampen inflation pres-sures in the second half of the year. However, in-creases in public transport fares, educational costsand most importantly water, gas and central heat-ing will continue to be major inflationary factors.Therefore average annual HICP inflation, will staydouble digit this year. We expect average inflation for2008 to reach 11.5 per cent.

As GDP growth slows in 2009, inflation should come

down to 8 per cent. A sharper decline in inflation willnot occur, since excise duties for fuel, alcoholicbeverages and tobacco are expected to increase.Electricity price hikes are also possible, pending deci-sions by utilities regulators. After the closure of Ignali-na nuclear power plant, electricity price increases in2010 will again re-ignite cost-push inflation pressure.We expect electricity price increases of 10-20 percent in 2009 and a further 80-90 per cent in 2010after the Ignalina closure. Our 2010 inflation forecastincludes direct effects of about 2.5 percentage points,plus indirect effects of another 1-1.5 percentagepoints.

Energy from RussiaThe chances of extending Ignalinas lifespan until2012 are shrinking, and the plant is expected to stopoperations on December 31, 2009 its closure couldshave up to 3 percentage points off GDP growth.Although a consultative referendum on an extensionof Ignalina operations will take place in conjunctionwith the parliamentary elections in October, EuropeanCommission President Jos Manuel Barroso recentlyreiterated the stance of the Commission by askingLithuania to comply with the terms of its EU acces-sion treaty.

However, the Commission and EU member states areincreasingly aware of the situation in the Lithuanianand regional energy market, and additional measuresand financial resources to mitigate the energy supplycrunch are expected. The economic cool-down inEurope and Russia will also slow the growth of de-mand for energy. Therefore the chances are increas-ing that Russia might have sufficient energy resourcesto satisfy demand in Lithuania. Yet political and cli-mate risks remain. While Lithuania is not expected tobe linked up with major energy markets in Scandina-via and Poland until 2015, apart from Russia it canstill import electricity from Estonia and Finland viaLatvia and from Ukraine via Belarus.

Looking further ahead, the energy situation in Lithua-nia and the region will be improved by constructingnew nuclear plants in Lithuania, Kaliningrad and Bela-rus. To lead and finance the nuclear project in Lithua-

nia, the government controversially merged a privateelectricity distribution company with state-owneddistribution and transmission companies, forming theholding company LEO LT. This company and itsconsortium partners in Poland, Latvia and Estonia areexpected to construct the plant by 2018. Decisions onthe size of the plant and the choice of technology willbe made during the spring of 2009.

Slower credit growthCredit growth is slowing. This reflects worseningeconomic sentiment and tighter lending conditions.

Increases in interest rates, high inflation and the ex-pectation of continued corrections in the real estatemarket have also dampened the appetite for newloans.

During the first half of 2008, the loan portfolios ofcommercial banks increased by 35.6 per cent year-on-year. We are lowering our full-year forecast to 25per cent and next years to 15 per cent.

Coalition government expectedParliamentary elections are scheduled to take place onOctober 12. Polls indicate that six parties will attractenough votes to win seats in Parliament. The outcomeis difficult to predict, as a sizeable number of undecid-ed voters will be attracted by the referendum on theIgnalina nuclear power plant, and their votes couldsignificantly alter the final composition of Parliament.A coalition government will probably have to beformed. Based on the economic programmes of theparties, two possible coalitions may emerge centre-left and centre-right. A centre-left government wouldlargely continue the policies of the incumbent govern-ment, while the centre-right parties have expressed anambition to tighten budget expenditures, streamline thepublic sector and promote foreign direct investment.


16/25


17/2517


Poland

and growth, rising interest rate spreads and financialconvergence in the wake of plans to adopt the euro.

Representatives of both the government and the Na-tional Bank of Poland (NBP) agree that constitutionalamendments shifting authority from the central bankto the ECB are needed and should be adopted beforeERM2 accession. In todays parliamentary situation,the 3/5 majority required for such amendments wouldprobably not be achieved. A referendum on the issue

is thus likely (with at least a 50 per cent voter turnoutrequired to be valid) and should take place during thespring of 2009.

Economic stabilisation needed aheadThe accelerated euro zone plan will require a tighterfiscal policy in order to keep the budget deficit com-fortably below 3 per cent of GDP, the MaastrichtTreaty ceiling. This will limit the governments roomfor stimulating the economy now that growth isslowing. There will also be less room for generouselection promises as Poland votes for its president in

2010 and Parliament in 2011. The budget deficit hasdecreased in recent years of strong GDP growth, andwe expect it to remain at about 2.5 per cent of GDP.

Monetary policy must also shift from the currentinflation target of 2.5 per cent 1 point to achieve theMaastricht-defined criterion in practice. Formally, thetarget is likely to be charged to HICP at 2.0 per centor lower. The NBP has announced that this will occurwhen euro adoption plans become firmer. In thecoming quarters Polish inflation will slow, thanks tofalling/stabilising commodity prices, previous interestrate hikes and weakening demand/wages. But given

our forecast of significantly lower inflation throughoutthe EU (and the strict Maastricht inflation criteria),Poland will probably require even tighter fiscal policy.We expect the real interest rate to rise as the key rate

remains at 6.0 percent despite falling inflation. Longerterm interest rates will, hower, fall.

Tolerance for a strong zloty will increase. Polandscurrency policy will also be tested. Our assessment isthat in practice, the zloty will only be allowed toweaken by 2.25 per cent from its central party rateagainst the euro upon ERM2 accession. It appearslikely that the zlotys ERM2 period may be far moreturbulent than that of the Slovakian koruna, in light of

a substantially more challenging global economicsituation. The main risks to achieving the goal of aeuro transition in 2011 (or 2012) is if the attempts toamend the constitution fail and if a deep economicslide erodes public support for the governing parties inthe run-up to the coming elections. We believe euroadoption in 2012 is slightly more probable than in2013.

Slow progress on the path to reformsThe reform-oriented governing coalition led by theCivic Platform party has a weak parliamentary base

but has taken the initiative towards joining the eurozone after a cautious first year in power. It remains tobe seen whether this will lead to progress in enactingreforms in such areas as the labour market and thehealth sector as well as continuing with privatisationsand dismantling bureaucratic obstacles.

So far, the pace of reform has been slow because theother coalition partner, the Polish Peasants Party, isless reform-minded. Prime Minister Donald Tusk isriding on a wave of popularity that he does not wishto jeopardise before the 2010 presidential election.Above all, President Lech Kaczynsky has announced

that he will veto most reforms. The coalition lacks the3/5 support in Parliament required to override presi-dential vetoes. In light of this, it is reasonable thatreform expectations are rather modest.

October 2008 Official timetable unveiled

Q4 2008 Application for ERM2 membership

Q1 Q2 2009 Referendum: constitutional amendments

April 2009 ERM2 membership. Fixing of centralparity rate

June 7, 2009 EU parliamentary elections, possibledate for referendum

2010 Measurement period for budget andpublic debt criteria

April 2009 Measurement period for inflationMarch 2010 and interest rate criteria

Q2 2010 Verification process (EuropeanCommission, Central Bank, Parliament)

Q2 Q3 2010 Approval (ECOFIN). Final exchange rate

Q4 2010 Practical preparations. Euro zonemembership technically possible

January 1, 2012 Euro zone membership, EUR transition

Euro transition in 2011?

On September 10, Prime Minister Donald Tusk madethe surprising announcement that Poland is aimingfor a transition to the euro in 2011. The central bank is

preparing to realign its monetary policy towards thisend. Euro zone membership by the end of 2001 is

technically possible, but a more likely date is 2012.The timetable might look something like this:


18/2518


Slovakia

Sharp slowdown fromhigh levels

n Private consumption still robust

n Euro adoption feeds inflation

n Strong public finances

Slovakia has experienced one of the highest levels ofeconomic growth in the Central European region overthe past few years. However, growth will be lessspectacular during the next couple of years, sinceinternational demand will be weak. Inflation is on therise, and euro zone accession in January 2009 isexpected to hamper the decline in inflation.

In the first quarter of 2008, the GDP growth rate was8.7 per cent. This was higher than in the same periodof 2007 but much slower than during the precedingquarter (11.5 per cent). In the second quarter, growthslowed further to 7.6 per cent, which was still thehighest rate in the EU. Weakening foreign demandmeans that the contribution of net exports will dimin-ish. However, it will be partly offset by growingconsumption. Our GDP growth forecast is 7 per centin 2008, 3.5 per cent in 2009 and 4.0 per cent in2010.

During January to June, Slovakia showed an increasein its current account deficit, which will probablywiden through the year. While the foreign trade sur-plus improved slightly, this was unable to offset dete-riorating service, income, and current transfer ac-counts. The biggest shift came on the service ac-count, which went from surplus to deficit, indicatingthat in this sector, Slovakia is perceived as less attrac-tive than neighbouring countries. During the first fivemonths, foreign direct investment reached a net in-flow of EUR 126 million, down from EUR 136 in theyear-earlier period. The economy is reaping the fruitsof the past investment boom and ongoing projects in

the automotive and electrical equipment industries.However, global developments and the completion of

ongoing projects suggest that FDI inflows will slowand that their peak has passed.

Job growth is continuing, and unemployment will

decline somewhat further but remain high comparedto other EU countries. Productivity growth is gradual-ly slowing as well.

Despite rising inflation, Slovakia met all the criteria foradopting the euro and will join the single currencyarea on January 1, 2009. By the end of this year,inflation should lose momentum due to favourablebase effects, although a rise in minimum wage andcost-driven inflation factors may start to dominate theinflation picture. Euro adoption will trigger slight priceincreases due to rounding off of prices and otherfactors. The government is trying to persuade energy

companies to moderate price increases. We expectinflation to average 3.5 per cent in 2008 and 3.6 percent next year and in 2010.

The conversion rate has now been set at 30.1260koruna to the euro, which corresponds to the currentcentral rate within ERM2. The switch to the EuropeanUnion single currency has created a buzz amongshoppers and consumers, since prices must be statedin both koruna and euro terms.

Solid public financesThe first half 2008 budget deficit was considerably

lower than a year earlier. The government approved apublic financial deficit target of 2.2 per cent of GDPfor 2009, compared to the 2.3 per cent originallyexpected. Revenue collection indicates that the gov-ernment will be able to exceed the target of its deficitreduction plan for this year, but the plan to introduce a13th monthly pension in order to boost social benefitsand lower GDP growth will hamper further tighteningin 2009. Owing to good budgetary performance,government debt is expected to diminish slightly in thenext couple of years.

The concerns that accompanied the formation of a

coalition between Prime Minister Robert Ficos Smer-Social Democracy party and two rightist parties haveproved largely unfounded. On the contrary, economicsuccess and political skills have contributed to Ficoscontinuously rising popularity. His cabinet faces amajor challenge in ensuring a smooth euro introduc-tion process. The government has thus pushedthrough a law that threatens fines and blacklisting forthose who take advantage of the currency transition.

Slovakia: EU sentiment indicator and GDP

GDP, year-on-year percentage change (LHS)EU sentiment indicator, index (RHS)

Sources: European Commission, Statistical Office of Republic of Slovakia

00 01 02 03 04 05 06 07 08

80

85

90

95

100

105

110

115

120

-2.5

0.0

2.5

5.0

7.5

10.0

12.5

15.0

17.5


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The Czech Republic

Past the peak

n Economy still resilient, slower growth

n Broad-based weakeningn Inflation the top challenge

The Czech economy is past its cyclical peak and iscooling down. However, the economy remains gener-ally resilient and has not seen any substantial impactfrom the global financial crisis. GDP growth waspreviously driven by foreign trade, but its strength willwane during the rest of 2008 and in 2009 owing tothe cool-down in most of Europe.

Reflecting weaker consumer spending and the stag-

nating euro zone economies, the Czech economyexpanded at its slowest pace in four years: 4.5 percentduring the second quarter of 2008, compared to 5.1per cent in the first quarter. Since both export growthand domestic demand are continuing to slow and thistrend will continue next year. The GDP growth fore-cast for this year is 4.1 per cent. We expect growth toslow further to 2.5 per cent in 2009, and we expectsome improvement in 2010.

During the first half of 2008, exports grew by 5.2 percent and imports by 4.8 per cent. The trade surplussurpassed last years performance but shrank duringthe second quarter. There will be further deteriorationin export volume and subsequently also in the tradeand the current account balance, the latter deteriorat-ing to minus 3.5 per cent of GDP in 2009.

On January 1, 2008 the Czech Republic introduced aflat income tax rate of 19 per cent, replacing fourprogressive rates and leaving most workers with morecash. In the second quarter, however, real wagesgrew at the slowest pace in almost ten years. Real

wage growth is likely to remain sluggish during therest of this year but will recover next year as inflationfalls. Combined with increasing unemployment, it will

slow the performance of the whole economy. Theeconomy consequently will rely more on foreign tradethan on the domestic sphere.

Consumer prices have climbed in the past year due totax changes as well as rising global commodity andfood prices. Inflation peaked at a nine-year high of 7.9per cent in January 2008. The continued rise in foodand energy prices has prevented any big slowdown ininflation. However, owing to a decline in the prices offood and non-alcoholic beverages and transport, year-on-yearconsumer price growth slowed to 6.2 percent in August, the lowest rate this year. In the firsttwo quarters of next year, we expect inflation tomoderate further. Due to base effects, 2009 inflationwill not reflect tax changes implemented in 2007. Theincrease in regulated prices will slow as well. We

forecast average inflation of 6.4 per cent this year,slowing to 3.0per cent in 2009 and 2.8 per cent in2010.

Further interest rate cutsEarly in the summer, the koruna climbed significantly,hitting records. The Czech National Bank cut its keyinterest rate by 25 basis points to 3.50 per cent inAugust. The CNB was reacting to the korunas ex-change rate against the euro, which dipped belowCZK 23, making it the first central bank in the regionto loosen policy. This was the first rate cut in more

than three years and was an attempt to counter thekorunas record appreciation to try to revive fadingeconomic growth. The slowing economy gives theCNB room for further easing of monetary conditions.It may decide to cut interest rates further this year,but the next move will depend on inflation develop-ments and expectations, as well as other factors. Thekey rate will bottom out at 2.75 per cent in 2009.

The korunas strength is not consistent with slowingdomestic growth. The exchange rate trend of thekoruna will take its toll on export performance and oninvestments. Our EUR/CZK forecast for the end of

2009 is 24.2.

Euro still elusiveThe Czech Republic has not yet fixed an official datefor euro adoption, but the business community ispushing the government to do so, in order to maintainthe attractiveness of the economy. As for joining theeuro zone, low inflation and public sector fiscal disci-pline will be the most important issues. The proposedbudget for 2009 should ensure a public sector deficitof 1.6 per cent of GDP. However, with growth fallingand elections coming up in 2010 we expect a moder-ate fiscal loosening. The government wants to contin-ue to reduce the gap to 1.2 per cent in 2012. Inflationhas thus become the main obstacle to euro adoption inthe next few years.

1009080706050403

8

7

6

5

4

3

2

1

0

-1

-2

4.0

3.5

3.0

2.5

2.0

1.5

Sources: Eurostat, Reuters Ecowin

Czech Republic: HICP and repo rateYear-on-year percentage change and per cent

HICP (LHS)

Repo rate (RHS)

SEB forecast

= yearlyaverage


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Hungary

Slower recovery

n Domestic demand is picking up

n Fiscal loosening from 2009n Sluggish decline in inflation

Hungary is starting to emerge from its economicproblems. The double deficit is back to more sus-tainable levels. GDP growth has recovered after avery slow trend last year. The main growth enginewill gradually shift from foreign demand back todomestic demand. In 2008, real GDP growth shouldreach 1.9 per cent. We foresee 2.2 per cent growth in2009 and 3.5 per cent in 2010. Inflation is headingdownward.

Tax reductions aheadAfter adopting its belt-tightening policies in September2006, the government has achieved the desired eco-nomic results. Harsh austerity measures helped reducethe budget deficit from 9.2 per cent of GDP in 2006to a projected 3.8 per cent in 2008. The governmentis consequently now considering a step in the oppositedirection, i.e. providing some fiscal stimulus to theeconomy. Early in September, Prime Minister FerencGyurscny proposed tax cuts equalling HUF 300billion (EUR 1.2 billion) in 2009 (1.1 per cent of GDP)

and HUF 1.2 trillion by 2012. The package includescutting the corporate tax rate from 20 to 18 per cent,lowering payroll taxes and making the lower of twopersonal income rates applicable to higher salaries.

If approved, this package would encourage economicgrowth. On the other hand, it may threaten to pushthe budget deficit much higher, since Mr Gyurscnyhas rejected cuts in social expenditures proposed bythe liberal Alliance of Free Democrats, which with-drew from his government last spring. The tax reduc-tion proposal sparked new controversy in the politicalarena. On October 11, a gathering of the ruling Social-ist party will decide whether to support the PrimeMinisters proposed early election. According to ourbase scenario, Gyurscny will remain in office butsome adjustments in his current proposals for fiscalpolicy reforms will be carried out before approval.The next parliamentary election is scheduled for 2010.

Comeback for the domestic marketAfter almost stagnating in 2007, this year the Hungari-an economy is showing somewhat more robustgrowth. In the first half of 2008, real GDP rose 1.9per cent year-on-year, compared to a 0.9 per centincrease in the second half of 2007. The economy

continues to be driven mainly by net exports. House-hold consumption also showed a minor increase inJanuary-June 2008. However, gross capital formation

and government expenditures were still declining,compared to the first half of 2007. This summer, theagricultural harvest almost doubled from the sameperiod a year ago, contributing significantly to the

countrys value-added. Construction earnings alsoimproved in the second quarter of 2008, largely owingto public tenders for motorways.

In the near future, domestic demand should recoverfurther, supported both by loosening fiscal and mone-tary policies. On the other hand, the labour market isrecovering slowly and banks are tightening their creditconditions in the face of the global liquidity crunch.There is a risk that the credit crunch may affectHungary more severely. Meanwhile, noticeable chal-lenges await net exports in the near future, as growthstalls in Hungarys main export markets (in the euro

zone) and competitiveness is eroded by the relativelystrong forint and high inflation.

Despite Hungarys poorer competitiveness and theweak economic growth in Western Europe, in the firsthalf of 2008 external trade moved into surplus from asubstantial and traditional deficit a year earlier.However, pressure on the current account will rise asexports are squeezed and imports accelerate due torecovering domestic demand. The current accountdeficit should fall to 6 per cent of GDP in 2008, 5.7per cent next year and 5.2 per cent in 2010.

In August 2008, year-on-year HICP inflation fell to 6.5per cent, its lowest rate since October 2006, helpedby stumbling domestic demand. Inflation is likely todrop further in the second half of this year due tofavourable base effects, declining food prices due tothe plentiful harvest and the effects of interest ratehikes last spring. However, administratively controlledgas and electricity prices are set to rise in the nextfew months. As consumption starts recovering, de-mand-pull pressures may also become a renewedpotential source of inflation next year. We are fore-casting average HICP inflation of 6.5 per cent in 2008,4.2 per cent in 2009 and 3.2 per cent in 2010.

Meanwhile, the National Bank of Hungary expectsinflation to fall to its 3 per cent target within threeyears. We thus expect NBH to adopt a dovish stancebut to do it slowly and to reduce its key interest rate,currently at 8.5 per cent, to 7.25 per cent by the endof 2009 and 6.5 per cent by the end of 2010.

Despite support against other major currencies, due tohigh interest rate differentials, the forint will be vul-nerable due to political turbulence and weak global


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21

Key economic data

CZECH REPUBLIC

2003 2004 2005 2006 2007 2008(f) 2009(f) 2010(f)GDP, % 3.6 4.2 6.1 6.4 6.5 4.1 2.5 3.3

Inflation, HICP, average, % -0.1 2.6 1.6 2.1 3.0 6.4 3.0 2.8Unemployment, ILO, % 7.8 8.3 7.9 7.1 5.3 4.7 5.0 4.6Current account, % of GDP -6.2 -6.0 -2.1 -3.1 -2.5 -2.4 -3.5 -3.5Public sector financial balance, % of GDP -6.6 -3.0 -3.6 -2.7 -1.6 -1.8 -2.3 -2.5Public sector debt, % of GDP 30.1 30.4 29.8 29.6 28.7 28.5 28.2 27.8EUR/CZK, end of period 32.40 30.30 29.00 27.50 26.60 25.50 24.20 23.00Key rate, eop 2.00 2.50 2.00 2.50 3.50 3.25 2.75 3.005-year government bond, eop 3.70 3.40 3.20 3.70 4.00 3.80 3.00 3.40

ESTONIA2003 2004 2005 2006 2007 2008 (f) 2009 (f) 2010 (f)

GDP, % 7.1 7.5 9.2 10.4 6.3 -1.5 -2.2 2.0Inflation, HICP, average, % 1.4 3.0 4.1 4.4 6.6 10.5 5.0 3.5Unemployment, % 10.0 9.7 7.9 5.9 4.7 5.5 7.0 6.0Current account, % of GDP -11.3 -12.3 -10.0 -15.5 -17.4 -10.0 -8.0 -8.5Public sector financial balance, % of GDP 2.0 2.3 2.3 3.8 2.9 -1.5 -1.0 -0.5Public sector debt, % of GDP 5.7 5.2 4.4 4.1 2.7 3.0 3.2 3.5EUR/EEK, end of period 15.6 15.6 15.6 15.6 15.6 15.6 15.6 15.63-month interest rate, eop 2.6 2.4 2.6 3.9 7.3 6.7 5.3 4.9

HUNGARY

2003 2004 2005 2006 2007 2008(f) 2009(f) 2010(f)GDP, % 4.2 4.8 4.1 3.9 1.3 1.9 2.2 3.5Inflation, HICP, average, % 4.7 6.8 3.5 4.0 7.9 6.5 4.2 3.2Unemployment, % 5.9 6.1 7.2 7.5 7.6 7.7 7.2 6.9Current account, % of GDP -7.9 -8.6 -7.5 -7.5 -6.4 -6.0 -5.7 -5.2Public sector financial balance, % of GDP -7.2 -6.5 -7.8 -9.2 -5.4 -3.8 -3.8 -3.5Public sector debt, % of GDP 58.0 59.4 61.6 65.6 66.0 63.0 61.0 60.0EUR/HUF, end of period 262.2 245.9 252.7 252.3 252.0 265.0 240.0 225.0

Key rate, eop 12.50 9.50 6.00 8.00 7.50 8.50 7.25 6.505-year government bond, eop 9.30 8.00 7.10 7.40 7.40 8.80 6.80 6.50

(f) = forecast


22/25


22

Key economic data

LATVIA

2003 2004 2005 2006 2007 2008(f) 2009(f) 2010(f)GDP, % 7.2 8.7 10.6 12.2 10.3 -0.5 -2.0 2.0

Inflation, HICP, average, % 2.9 6.2 6.9 6.6 10.1 16.1 8.0 5.0Unemployment, % 10.6 10.4 8.7 6.8 6.0 7.0 9.0 8.5Current account, % of GDP -8.2 -12.8 -12.5 -22.5 -23.8 -13.5 -10.0 -8.5Public sector financial balance, % of GDP -1.6 -1.0 -0.4 -0.2 0.0 -1.5 -3.0 0.0Public sector debt, % of GDP 14.4 14.5 12.0 10.0 9.3 9.0 9.3 9.5EUR/LVL, end of period 0.67 0.70 0.70 0.70 0.70 0.70 0.71 0.70Key rate, eop 3.00 3.50 4.00 5.00 6.50 6.00 5.50 5.505-year government bond, eop 4.60 4.00 3.20 4.90 7.50 7.50 7.00 6.50

LITHUANIA

2003 2004 2005 2006 2007 2008(f) 2009(f) 2010(f)GDP, % 10.2 7.4 7.8 7.8 8.9 5.5 2.0 1.0Inflation, HICP, average, % -1.1 1.2 2.7 3.8 5.8 11.5 8.0 11.0Unemployment, % 12.4 11.4 8.3 5.6 4.3 5.0 6.5 7.0Current account, % of GDP -6.8 -7.7 -7.1 -10.6 -14.6 -12.0 -10.0 -11.0Public sector financial balance, % of GDP -1.3 -1.5 -0.5 -0.4 -1.2 -1.5 -1.5 -2.0Public sector debt, % of GDP 21.1 19.4 18.4 18.0 17.0 14.5 16.0 17.0EUR/LTL, end of period 3.45 3.45 3.45 3

seb eastern europe outlook seb_eeo_10_2008

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