While a good deal of investor attention has been focused on the US of late, in the process relegating the EU debt crisis into clear second place, CEE economies have been largely subjected to benign neglect. Arguably this is a mistake, since a lot can be learnt from following the evolution of these economies, many of which are undergoing a rapid transition from being emerging prospects to over-mature stars of yesteryear. The unique demographics which are to be found in the region make them a fascinating laboratory for what might happen in other parts of the world, most notably China, as we move into the 2020s.
The Baltics, Hungary, Romania and Bulgaria all have interesting things to teach us. But these could be dismissed as being examples of weaker economic (not to mention on occasion basket) cases. So, what about the stronger ones, like the Czech Republic and Slovenia?
Well the Czech Republic is now in recession, and in fact the last time the economy actually grew was in the second quarter of 2011. It is now moving sideways, and the key question is what is the real growth potential of this economy in the future.
If you believe the numbers conjured up by the IMF we should expect annual growth of about 3.5% once the recession ends. We think this is way too high, and that such optimism has little justification in reality. It could even be a good example of what Christine Lagarde recently called “wishful thinking”.
The demographics are quite unique in the CEE. Due to the rapid declines in fertility which even go back to the soviet era, many of the countries in the region started to get old before they started to get rich. If this assessment is right then we think we won’t see US or UK like household debt levels there before consumption growth peaks. Indeed we should rather expect to see the characteristics of a super mature economy – like Germany or Japan – setting in at a younger population age. In fact this is exactly the phenomenon we think we are observing now in the Czech Republic.
In recent years Czech exports have performed remarkably well, and the country has a strong goods trade surplus. The problem is that most of the country’s exports have been geared to the European market, and consumption in this area is now stagnant with a tendency to decline. So the economy languishes in recession.
The thing about elderly economies is that they no longer stand on two pillars, domestic consumption steadily runs out of steam, and the economy becomes export dependent. This is what can be observed in the Czech Republic, and the country’s demographics make us doubtful we will ever see strong growth in private consumption again.
The country has a low sovereign debt level – around 45% of GDP – and maintains a reasonably strict fiscal discipline, despite the fact that with an ageing population the costs of health care and pensions continue rising annually.
One of the reasons for the low sovereign debt level is the fact the country privatized a number of its state owned companies at the start of the century. In addition, the banking sector has ample liquidity. In the words of central bank Governor Miroslav Singer: “We have a liquid financial system already. We never had liquidity problems so we wouldn’t achieve very much by putting in quantitative easing. We are in a more traditional ball game.” This positive outlook exists due to the continued funding of the Czech banking system by Austrian and Italian Banks. Further, the country receives a steady inflow of FDI.
But all of this has a downside, in terms of the steadily worsening Net International Investment Position of the country. Indeed the income outflow on portfolio investments and loans means that despite the trade surplus the country runs a small current account deficit.
So all of this raises the issue of long run sustainability for the country. It is now the second oldest one in the entire CEE region, coming in just behind Slovenia which is also facing a consumption-collapse driven identity crisis.
The country enjoys the benefits of independent monetary policy, and if the central bank governor is to be taken at his word, we are likely to see efforts to lower the value of the Krona over the coming months. As he said, with interest rates at a record 0.05% low, and buying government debt most unlikely, we are probably going to see the more traditional method of currency intervention applied in an attempt to gain export share.
Yet despite being out of the Euro, and having the ability to devalue, we are not sure about the extent to which the Czech government will be able to withstand popular pressure to increase spending in the face of a stagnant economy. Despite introducing a constitutional change limiting public debt to 50% of GDP, as we are seeing in the Polish case such laws are easier to enact than implement. It is likely the current austerity policies will increasingly come into question if, as we foresee, the economy continues to stagnate. In which case watch out for credit rating downgrades, and future surges in yield spreads.