Eastern European Outlook 1303: Continued decent growth in North-eastern Europe

7/29/2019 Eastern European Outlook 1303: Continued decent growth in North-eastern Europe

1/24

Continued decent growthin northern Eastern Europe

Theme: Euro timetable

Eastern European

OutlookEconomic Research March 2013


2/24

Eastern European Outlook March 2013 | 3

Economic Research

Eastern European Outlookis produced twice a year. This report was published on March 20, 2013.It was written by Mikael Johansson (Chie Editor), Andreas Johnson, Dainis Gaspuitis, Ruta Arume and Vilija Tauraite.

Robert Bergqvist Hkan FrisnChie Economist Head o Economic Research+ 46 8 506 230 16 + 46 8 763 80 67

Daniel Bergvall Mattias BrurEconomist Economist+46 8 763 85 94 + 46 8 763 85 06

Ann Enshagen Lavebrink Mikael JohanssonEditorial Assistant Economist, Head o CEE Research+ 46 8 763 80 77 + 46 8 763 80 93

Andreas Johnson Tomas LindstrmEconomist Economist+46 8 763 80 32 + 46 8 763 80 28

Gunilla Nystrm Ingela HemmingGlobal Head o Personal Finance Research Global Head o Small Business Research+ 46 8 763 65 81 + 46 8 763 82 97

Susanne Eliasson Johanna WahlstenPersonal Finance Analyst Small Business Analyst+ 46 8 763 65 88 + 46 8 763 80 72

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

Ruta Arume Dainis GaspuitisEconomist, SEB in Tallinn Economist, SEB in Riga

+372 6655173 +371 67779994

Gitanas Nauseda Vilija TauraiteChie Economist, SEB in Vilnius Economist, SEB in Vilnius+370 5 2682517 +370 5 2682521


3/24

Summary

4 | Eastern European Outlook March 2013

Economic growth in Eastern (including Central) Europe has bottomed out in the past 3-6 months, as in the West. And like thepattern in Western Europe, the northern part o Eastern Europe is perorming better than the southern part. The Baltic coun-

tries in particular, but also Russia and Poland, will continue to show decent GDP increases during 2013-2014 while Ukraine

will remain mired in economic stagnation this year as well. Countries in central and southern parts o the region, such as the

Czech Republic and Hungary, are climbing extremely slowly out o recession while Croatia and Slovenia will continue to show

negative growth.

The northern part o Eastern Europe is displaying relatively good resilience to the global slowdown and the euro zone debt

crisis, mainly since their economies and banking sectors are in relatively good undamental shape and because Russia is

beneting rom continued high oil prices o around USD 110/barrel. Countries in the southern part o the region have larger

internal imbalances and their banks are squeezed more by the problems in Western Europe.

Unemployment is gradually alling in the Baltics and Russia but will rise in Poland this year and remain high in Ukraine. Large

emigration rom the Baltics in recent years is causing some bottleneck problems in their labour markets. Although pay in-creases are generally speeding up, the cost situation is under control with the possible exception o Estonia. Export competi-

tiveness thus remains good, ater earlier internal devaluations. In Russia, the jobless rate has already dropped below its equi-

librium level, generating cost pressures and growth problems generally. This year, infation will continue to all in the Baltics

and Poland but rise somewhat in Russia and rebound clearly in Ukraine, despite its economic crisis.

Here are our GDP orecasts or the six countries that Eastern European Outlookcovers:

Russias growth will cool slightly to 3.0 per cent this year and 3.5 per cent in 2014. The economy is already hitting its

resource ceiling, and ar-reaching reorms will be needed to lit its growth potential to President Vladimir Putins 5-6 per

cent target.

Poland is recovering rom a deep domestic slump, aided in part by the big decline in interest rates over the past six

months but the central bank is nished cutting interest rates. This year, GDP will increase about as much as last year,

2.1 per cent. In 2014, growth will speed up to 3.5 per cent, still below the potential rate o around 4 per cent.

Ukraine will see zero growth again this year, and GDP will rise 1.8 per cent in 2014. The economy is squeezed by a big

current account decit and sagging condence. A new IMF bail-out loan is needed; we expect a devaluation in the second

quarter.

Estonias growth will accelerate rom 3.2 per cent last year to 3.8 per cent in 2013 and 3.7 per cent in 2014. This is still

below potential, which is roughly 4 per cent in the Baltic countries. As elsewhere in the Baltics, growth will be relatively

balanced.

Latvia remains the astest-growing EU country. A temporary dip rom last years 5.5 per cent to 3.8 per cent will occur this

year. In 2014, growth will revert to 5 per cent.

Lithuanias GDP will increase by 3.2 per cent this year and 3.5 per cent in 2014, ater last years 3.6 per cent growth.

Latvia will convert to the euro in 2014 as planned. The country meets all Maastricht criteria by a wide margin. But no waveo new euro zone memberships by the EU countries in Eastern Europe can be expected; or most o them, accession will be

delayed or some years. The main reason is that, except or Lithuania, their governments have made adopting the common

currency a lower priority due to the euro zone crisis.


4/24

The international economy


Growth has bottomed out, but the recovery is sluggish Deleveraging and political uncertainty

Euro zone will stay in recession this year too

The euro will weaken

The world economy is moving in the right directionatergreat weakness late in 2012 in many countries, especially inWestern Europe. But this is occurring at a slow pace, andmainly emerging economies are sustaining improved growth. InEurope, unemployment will continue rising this year. Recoveryis being held back by heightened economic policy uncer-

tainty and because many governments, households and banks,especially in the West, have not yet achieved their delever-aging targets ater the nancial crisis. Sources o politicaluncertainty include US budget policy, Chinas new long-termgrowth model, the euro zones stumbling progress towardspolitical union, Spains bail-out needs and the long-term risko Greek withdrawal rom the euro zone. In this uncertain,economically tough environment, businesses will continue tohesitate about investments this year. But in the US we expect athaw in capital spending ater this spring, once scal policy has

become clearer. We predict a compromise solution betweenDemocrats and Republicans, resulting in a scal tighteningeect totalling some 2.0 per cent o GDP this year, a long-termincrease in the ederal debt ceiling and public debt that willpeak in 2015 at about 115 per cent o GDP.

Meanwhile positive growth orces are in motion. Centralbanks will set new monetary stimulus records in 2013. Thereis room or this because large idle resources mean continuedlow core ination. In the past year, central banksrst inGermany and later in Japan and the UKhave also indicateda willingness to allow more ination. Financial stress in crisis-hit euro zone countries has eased greatly, ollowing major

downturns in long-term bond yields since last summer. Globalstock markets have climbed relatively sharply. In the past 3-6months, industrial indicators have cautiously begun torise. In February 2013, PMI in the US was 54 and China andGermany were slightly above the expansion threshold o 50.The recovery in the US and China is on increasingly rmground. Among actors helping sustain US growth are thathousehold deleveraging has made major progress and thathousing and construction markets have bounced back convinc-ingly; we predict that home prices will climb 5 per cent thisyear. Japans new ocus on stimulus-driven growthwill helplit global growth in the short term. Greater exibility in glob-

al scal consolidation and in implementing the new BaselIII banking regulations will reduce their negative impact ongrowth. Among other positive actors is that imbalances inEurope are shrinking; crisis-hit countries are improving theircompetitiveness via lower wages and large current account

decits have already shrunk noticeably. Overall, global growthwill gradually rise to 3.7 per cent in 2013 and 4.1 per cent in

2014; the latter is close to trend.

Euro zone GDP will still all this yearby 0.3 per cent, only aslightly smaller decline than in 2012. The reason is the nega-tive trend in crisis-hit countries. Only in 2014 will the euro zoneachieve growth. Germany, which has relatively small imbal-ances and is carrying out some scal stimulus this year, willcontinue to escape recession. GDP will rise by 0.6 per cent

in 2013 and 1.6 per cent next year. German economic growth isespecially important or Central Europe; or example Germanybuys about 30 per cent o Polish and Czech exports.

Demand in Eastern ( including Central) Europe will also

strength a bit ater bottoming out in many countries late in2012. Sentiment indicators have recently stabilised and im-proved slightly. But the regional divergence typical o EasternEurope in the past year or two will continue in 2013. Withtheir stronger undamentals, Russia and Poland will maintainbetter growth than many other countries, although the trendo Polish domestic demand and thus GDP growth were a cleardisappointment in the second hal o 2012. Some central and

especially southern parts o the region remain more depressed;or example, the Czech Republic and Hungary are climbingextremely slowly out o their 2012 recession. We expect bothSlovenia and Croatia to show negative growth again in 2013ater about a 2 per cent GDP decline last year.

Credit supply and unding costs at Eastern European bankshave greatly improved since summer, as in the West. But creditconditions or customers are thawing only slowly. Creditdemand is generally low except in a ew countries like Russia.

Global key dataGDP, year-on-year percentage change

2011 2012 2013 2014United States 1.8 2.2 2.1 2.7Euro zone 1.4 -0.5 -0.3 0.9The world 3.8 3.3 3.7 4.1Oil, USD/barrel 112.3 111.8 109.9 110.0EUR/USD, Dec 1.29 1.32 1.28 1.20Source: IMF, SEB

The euro will again all against the US dollar ater rising sincelast summer, largely due to the ECBs determined signals andreadiness (the OTM programme) to save the euro, greatercondence in scal consolidation by crisis countries and new

US quantitative easing. The remaining need or crisis countriesto improve their competitiveness will be one actor behind anew EUR weakening. The USD will recover due to relative USgrowth advantages and because the market will price in theFeds gradual exit rom its ultra-loose monetary policy.


5/24

Theme: Eastern Europes timetable


Euro zone accession will take some years or most Euro zone crisis makes leaders cautious

Few meet ination and currency criteria

Only Latvia ready or early accession 2014

On March 5, 2013, Latvia submitted to Brussels its ormal ap-plication or euro zone membership in 2014. The applicationwas expected. Ever since 2009, when Valdis Dombrovskis tookofce as prime minister amidst a deep economic crisis, theLatvian government had been clearly determined to adopt theeuro. Over the past two years, the government has declared2014 as its target date. For a long time, our assessment hasbeen that Latvia will also get the green light ater this

springs ECB and EU evaluation reports. On January 1,

2014, Latvia will thus become the 18th euro zone member.This will make it the ourth Eastern European nation to join,ater Estonia (2011), Slovakia (2009) and Slovenia (2007).

But we cannot expect a wave o accessions by the other

six non-euro zone EU members in Eastern Europe over thenext couple o years. There are several reasons:

1. In recent years, the euro zone debt crisis has caused mostEastern European governments to give the euro question alower priority on their political agenda. The crisis has madeit unclear what direction the euro zone is headed in terms osupranational scal policies and the stability o the euro in gen-eral. Consequently, some governments have cut back on theirambitions to pursue economic policies that will quickly leadto economic convergence in order to live up to the Maastrichtcriteria (or details, see ootnote to adjacent table).

2.Only Latvia and Lithuania have joined the ExchangeRate Mechanism (in 2005 and 2004, respectively), in which at

least two years o participation are required beore euro zoneaccession. The act that the other ve countries have not joinedthe ERM clearly indicates that the euro question has beenmoved lower on the political agenda, as stated in point 1.

3.Weaker Eastern European economic perormance inrecent yearspartly due to the euro zone crisis and recessionwith sagging GDP growth and even recession last year in po-tential euro zone candidates Hungary and the Czech Republic,make it harder to ull the Maastricht budget criterion. Taxrevenues have allen and unemployment benets have risen,along with other social spending.

4.Ination is too high in most o these countries compared tothe Maastricht ination criteriona moving target calculatedon the basis o the latest available data beore the EU/ECBevaluations. At that time, the criterion equals ination in the

three EU countries with the lowest ination plus 1.5 percent-age points. It may remain difcult to meet this criterion overthe next couple o years since ination will probably be pusheddown urther in the wake o large slack in the EU economies,partly due to a continued rise in unemployment this year.

We have examined how well the potential euro candidatesin Eastern Europe are currently perorming relative to the

most vital convergence criteria or euro zone accession:the three that cover price stability and sound public nances.Our review is based on outcomes/orecasts or 2012 rom theEuropean Commission or ination, budget decits and debt.

How well EU members in Eastern Europe outsidethe euro zone ull key Maastricht criteria*

2012 outcomes/orecasts according to European Commissionwinter 2013 report. Red gures = shortalls

Ination Budget Debt

% % o GDP SameBulgaria 2.4 -0.1 18.9Latvia 2.3 -1.5 41.9Lithuania 3.2 -3.2 41.1

Poland 3.7 -3.5 55.8Romania 3.4 -2.9 38.0Czech Republic 3.5 -5.2 45.5Hungary 5.7 -2.4 78.6

*Ination at the time o evaluation may not be higher than1.5 percentage points above the yearly average or the threeEU countries with the lowest ination: 2.77 per cent in 2012;which was used in our evaluation.The general governmentbudget defcitmay not exceed 3 per cent o GDP. Governmentdebtmay not exceed 60 per cent o GDP or must be mov-ing down towards this level at a satisactory pace. Beyondthese three central criteria, there are three others: Long-term

government bond yields may not exceed 2 percentage pointsabove those o the three EU countries with the lowest ina-tion. The exchange rate must have been stable or two years,with ERM membership and no devaluation. The central bankmust be politically independent. Worth noting is that whenthe ECB and EU evaluate whether a country meets the Maas-tricht criteria, they also assess whether there has been a long-term deceleration in its ination rate and budget decit.

Source: European Commission, SEB

We can draw the ollowing conclusions rom our review. Onlytwo o seven EU members in Eastern Europe outside the

euro zone currently meet the three most important Maas-tricht criteria: Latvia and Bulgaria. Latvia also meets the

other three criteria, while Bulgaria alls short because it

is not/has not been an ERM participant. No ewer than ve


6/24


Theme: Euro timetable

o the seven exceed the ination limit, all by relatively widemargins, especially Hungary. Four countries meet the budgetcriterion; o the other three, only the Czech Republic is wide othe mark. The criterion where Eastern European convergencescores are best is public sector debt; only Hungary ails the test,with public debt o nearly 80 per cent o GDP, while most o

the others are well below the 60 per cent ceiling. These EasternEuropean EU members thus have signicantly better publicsector debt positions than most Western European countries,including the current euro zone members.

Below is our euro timetable orecast or the seven non-eurozone EU members in Eastern Europe, in chronological order.

Latvia, 2014Latvia will convert to the euro in 2014, as planned. The countrymeets all Maastricht criteria by a wide margin. It is also di-cult to accuse Latvia o using quick-x economic policies toorce down ination and budget decits. The downward trend

o recent years appears lasting ahead a year or two. Note thatconvergence towards uture euro zone accession was also onekey objective o Latvias EU/IMF-led international loan packagein 2008-2011. Another reason we believe Latvia will be admit-ted to the euro zone is that the EU probably wants to show thatthe euro process is alive, despite the current economic crisis invarious member countries.

Lithuania, 2015 at the earliestThere is a 50-50 chance that Lithuania will achieve the 2015target date established by the centre-let government that tookofce ater last autumns parliamentary election. The previous

government had set an overly ambitious accession target o2014. The country has decent potential to meet the budgetcriterion, but during the coming year it may be tricky to bringdown ination sufciently; the evaluation will cover the year-on-year average or March 2013 to March 2014.

Poland, 2016 at the earliestPoland has no target date. This winter, Prime Minister DonaldTusk reiterated the countrys cautious stance on the euroquestion: Poland will aim at meeting the convergence criteriaas soon as possible, but what is crucial to a decision to adoptthe euro is ensuring that it is 100 per cent sae or Poland. Inother words, the euro zone must also be ready, Tusk told Parlia-

ment on February 19, 2013. Our assessment is that the criteriawill be easily within reach or accession in 2016, provided Po-land chooses to join the ERM no later than 2014.

Bulgaria, 2016 at the earliestBulgaria has no target date. In 2010, ormer Prime MinisterBoyko Borisov said that Bulgaria was then aiming or euro zoneaccession by 2013. Enthusiasm on the euro question remainedhigh until the autumn o 2012, when Borisov and ormer Fi-nance Minister Simeon Djankov openly and rankly declaredthat Bulgaria had shelved its plans to adopt the euro: Rightnow, I dont see any benets o entering the euro zone, only

costs, Djankov told the Wall Street Journalon September 3. Headded that disunity among euro zone countries on dealing withthe debt crisis and lack o the clarity about new rules made ittoo risky or Bulgaria to join the euro zone. This represents a

signicant cooling in Bulgarias euro ambitions. Nor is it likelythat the new government o Marin Raikovinstalled ater asudden shit in February when the Borisov government wasorced out due to massive popular discontent with its austeritypolicieswill choose to pursue the issue o euro zone acces-sion. Bulgaria actually meets the Maastricht criteria already

(except or ERM), but the politically uncertain situation makemembership beore 2016 improbable.

Romania, 2016 at the earliestRomania has no target date. Its previous target, 2015, wasscrapped in the autumn o 2012. Central bank Governor MugurIsarescu said very rmly at that time that the euro question waso the agenda, although he added that the country should con-tinue to aim at meeting the Maastricht criteria in order to dem-onstrate good discipline. The country is already well on its wayto ullling the criteria, aside rom its excessively high ination.But the euro question is clearly a lower priority than beore,making Romanian accession beore 2016 unlikely.

Hungary, 2018-2020Hungary has no target date. In recent years, political signalshave indicated that the euro question is ice cold and that ac-cession will not occur until 2018 at the earliest. In addition,Hungary today has very tense relations with the EU ater theViktor Orban governments controversial amendments to theconstitution, which the European Commission and the Councilo Europe believe will threaten the rule o law. Hungary is alsoin bad shape as regards ullling the criteria, with ar too highination and public sector debt.

Czech Republic, 2018-2020The Czech Republic has no target date. Just as in Hungary, eurozone ambitions have been clearly toned down. The governmenthas said it rst wants a reerendum on the issue and that thekoruna will be replaced by the euro no earlier than 2020. Alsonotable is that the central bank and nance ministry made ajoint statement in December 2012 on the Internet making itvery clear that euro zone membership will not be a priority:No target date will be set during 2013 and the country will notjoin the ERM this year. In economic terms, the Czech Republichas excessively high ination, but above all its continued largebudget decit makes euro zone accession eel very distant.


7/24

Estonia


Domestic demand shows resilience, exports shaky Household sector still deleveraging

Growing emigration a big challenge

Ination levelling out, high wage growth anupside risk

Contrary to developments in the euro zone and Nordic coun-tries, Estonian economic growth rates accelerated during thesecond hal o 2012, ater a slowdown in the rst hal. On aquarterly basis, the economy bottomed out in the rst hal o2012 year-on-year and accelerated to 3.7 per cent in the ourthquarter. Domestic demand remained the main driver. But in thelast quarter o 2012, exports also quite successully resistedthe slowdown in major export markets and the recession in theeuro zone, growing at a 7.1 per cent year-on-year rate. Exportperormance is quite shaky and vulnerable to sudden setbacks,but with Estonias gradually improving prospects in exportmarkets, our main scenario is modest growth in exports thisyear and improving prospects in 2014. Domestic demand isresilient. Capital spending was by ar the biggest driver o eco-nomic growth in 2012 but will likely shrink in importance dur-

ing 2013 because o slowing public investments, while privateconsumption will increase its contribution to growth. All in all,the economy should show a relatively balanced growth path.We expect GDP to rise by 3.8 per cent in 2013 and 3.7 per

cent in 2014.

Balanced growth is resulting in a small current account decit.During the nal quarter o 2012, this decit widened somewhatbecause merchandise imports surged and merchandise exportsgrew only modestly. The reason was strong domestic demandgrowth, even though there was a slight deceleration in privateconsumption and a more noticeable deceleration in capitalspending growth. The construction sector relinquished its roleas a growth driver. But what boosted domestic demand waspublic consumption growth, which is going to be temporary.

Construction volume growth decelerated sharply in the secondhal o 2012. Aside rom temporary government spending,growth drivers in the ourth quarter included the inormationand communication, transport and agricultural sectors.

The capital spending increase in the private sector is comingat the right time in 2013, as public sector investments are setto decrease. Increased investment activity is also reected invigorously expanded lending to companies during the secondhal o 2012 and early in 2013.

Households, on the contrary, are quite cautious in taking onnew loans. Total lending to individuals was still decreasingas o January 2013, and the loans granted monthly stopped

rising late in 2012. Household debt as a share o GDP went upduring the pre-crisis years rom about 20 per cent in 2004,peaking at 54 per cent in 2009. Ater that it decreased to 41 percent at the end o 2012. The level is still slightly higher than atthe end o 2006 when the economic boom was in ull swing.As or home mortgage loans, individuals may stop deleverag-ing during 2013, and there are initial signs o revival in loandemand.

Real wage increases have gradually recovered but were still a

rather modest 2.4 per cent in the last quarter o 2012 in year-on-year terms. We expect real wage increases to continuein 2013 and support private consumption. Disposable in-come will also be lited by a cut in unemployment insurance taxand increased social transers, such as child benets, athersbenets and pensions. Social benets will rise by 6 per cent. Allin all, private we expect private consumption to increase by 4per cent in 2013 and 3 per cent in 2014.

Real estate prices are gradually recovering, rising by 7-8 percent year-on-year. However, no housing boom is likely in thenear uture. Prices are not being driven by increased loan de-mand by households, but more because real estate is seen asan investment opportunity in the environment o very low inter-est rates. The majority o real estate transactions take placewithout bank loans.

General economic sentiment was relatively stable during 2012.Estonia remained among the most optimistic countriesin Europe, just behind Latvia. Business sentiment has beenstable, with the only exception being the manuacturing sec-tor, where condence ell at the end o the year. Consumer

condence deteriorated slightly during the ourth quarter butsurged again at the beginning o 2013.


8/24


Estonia

Manuacturing still aces a relatively tight external environ-ment. With a gradual improvement in external demand, exportsshould be capable o continued moderate growth in 2013,though risks remain high and setbacks may occur.

The biggest macroeconomic problem in Estonia is grow-ing emigration and the resulting labour market tensions.In 2012, emigration rose abruptly to nearly 10,900 people,or 4,600 more than the previous year. This was the biggestoutow o people in a decade. At the same time, the naturalrate o population decline worsened during the past two years.This will adversely aect the available workorce both in theshort and long term. The labour shortage is already the biggestobstacle to expanding businesses in Estonia. The most acuteshortage o labour is or relatively low value-added jobs in theservice sector, with richer neighbouring countries luring awaythe workorce that could perorm these low-paid jobs.

Because employment has increased at the same pace as out-put, productivity has remained practically unchanged or thepast two years. Meanwhile wage growth has surpassed theproductivity increase. It is about time to turn this trend around,and the rst signs o rising productivity can already be seen.Widespread pay increases are also projected, or example inthe public sector, as a result o strikes in the medical sector andamong pilots. Collective wage agreements have been reachedin the energy sector, along with minimum wages. Public sectoremployees constitute about a quarter o the workorce. There

will also be a continuing post-crisis pay adjustment process inthe private sector, although the situation varies between sec-tors. Prospects or wage increases are lower in sectors with ameagre chance o growth in output, such as manuacturing andconstruction.

At the same time, there is still huge reserve o available joblessindividuals. The unemployment rate decreased throughout2012 to 9.3 per cent in the ourth quarter. Further slight im-provements are expected, albeit at slower pace. The largestnumber o vacancies is or service workers, sales people andunskilled blue-collar workers. The same unskilled workers areone o the main categories o the unemployed. Supply and

demand do not match, perhaps because o wage levels orqualitative obstacles. The average wage grew by 5.9 per centin 2012 and is expected to rise by 7-8 per cent in 2013and5-6 per cent in 2014.

Increasing wages will generate ination risks or 2013. Other-wise inationary orces are relatively muted. Imported ina-tion will be subdued and commodity prices will not be pushingup ination. In January 2012, overall ination was at its lowestlevel in two years, even though an electricity price jump had asubstantial impact on the ination rate, 0.9 percentage points.

Underlying inationary orces are thus quite low, althoughthere is a lingering risk o spill-over eects rom the electricityprice increase. We orecast average annual ination o 3.3 percent this year and in 2014.

Economic perormance was much better in the second hal o2012 than expected by the Ministry o Finance. The govern-ment budget thus ended up in a better position than planned.Revenue surpassed the projected amount by 3.4 per cent, thus

leading to the smaller decit than the government hadexpected or 2012. The scal decit planned or 2013 amountsto 0.7 per cent o GDP.

This is also a local election year, which might boost themunicipal government decits and increase household incomeas well as investment projects. One apparent eect becamevisible at the beginning o 2013, in the orm o ree public trans-port in Tallinn, the capital. This boosts the disposable incomeo the low-income population and the popularity o the citysruling Centre Party, which is part o the parliamentary opposi-tion at national level.

Parliamentary support or the government has decreasedduring the past six months, because o a nancing scandallinked to the main ruling Reorm party. Meanwhile the partysconservative coalition partner, IRL, has gained in popularity.Overall, the right-wing government does not eel very threat-ened by the increased popularity o letist opposition parties.This shit partly reects widespread discontent with incomelevels, a recent hike in electricity prices and various politicaldevelopments. There were more strikes in 2012 than everbeore in Estonian history. The next parliamentary election isscheduled or 2015.


9/24

Latvia


Temporary slowdown in 2013 Domestic demand supports growth

Weak price pressure

Latvia will adopt euro in 2014 as planned

Despite weak global growth, 2012 turned out to be anotherboom year or Latvia, which succeeded in remaining theastest-growing economy in the EU or the second year in a row.Unemployment continued to shrink. At the same time, ina-tion stayed low, contributing to improved purchasing power.These avourable trends helped encourage private consump-tion. Good growth ensured that the government revenue planwas exceeded, resulting in additional unding rom the budgetto major sectors. The countrys macroeconomic stabilityled international rating agencies to lit Latvias rating. As trustincreased, Latvia was able to attract nancing at unprecedent-edly low interest rates.

In the ourth quarter o 2012, GDP increased by 5.1 per centyear-on-year, and ull-year growth was 5.6 per cent. Trade,manuacturing and construction showed solid growth. Thecrisis in the euro zone will continue to cloud the global outlookin 2013, so Latvian growth prospects must still be assessedwith some caution. However, until now, the Latvian economyhas demonstrated exibility and an ability to seize opportuni-ties in new markets. We oresee that current economic trendswill continue, though at a slightly more moderate pace. Weexpect GDP to grow by 3.8 per cent this year and growth

accelerate to 5 per cent next year. In 2013,GDP growthwill be sustained mainly by capital spending and private con-

sumption, boosted by higher wages and purchasing powerand by relatively stable sentiment. The transit sector will acecompetition and capacity constraints that are likely to result inslower growth. Activity in the real estate market will increase

slowly rom a low level. It is still aected by uncertain long-termprospects and the recent crisis. Construction will continue torecover, but at a slower pace than in 2012, whereas the nan-cial and insurance services industry will continue to adapt topost-crisis conditions.

In 2012 manuacturinga major employment and growthdriverincreased its sales in current prices by 11.9 per centcompared to 2011. In the nal quarter, export growth pickedup despite global weakness. During 2012, exports in current

prices increased by 15 per cent year-on-year, while imports rose12.7 per cent. We oresee that due to healthy competitiveness,manuacturing output and exports will continue to increase.Uncertainty is aecting capital spending, and businesses muststill work very efciently and avoid creating large inventories.Such caution restricts Latvias long-term development pros-pects. During 2013 we believe that investment activity will pickup gradually, partly as an eect o increased oreign invest-ments ahead o Latvias expected euro zone accession in 2014.

In 2012, the current account decit contracted to 1.7 per cento GDP rom 2.2 per cent in 2011. The reason was that exportsheld up better than expected and caution about capital spend-

ing curbed imports. We expect the current account decit toincrease modestly in the coming years due to higher imports.

In order to boost competitiveness and decrease the tax burdenon labour, starting in January 2013 personal income tax waslowered by one percentage point to 24 per cent. A two percent-age point cut will take eect in January 2014 and another a yearlater.

Impressed by the upcoming avourable tax changes and thepositive economic trend, consumers remained very active inthe second hal o 2012. Retailers increased their sales in con-stant prices by 9.7 per cent year-on-year in 2012. Going or-


10/24


Latvia

ward, we expect that households will not curb spending muchand we thereore expect a urther relatively robust increasein consumption this and next year.

Driven by global trends and moderate wage growth, inationcontinued to slow. As a result, year-on-year ination decreasedto 0.3 per cent in February. The impact o external actors willremain weak. This will allow urther improvement in householdpurchasing power and acilitate consumption. The continuedeconomic recovery will start to increase upward pressure onprices only gradually. This pressure will be limited, due to highunemployment and modest but increasing wage growth. Weorecast average annual ination o 1.4 per cent this year

but oresee an acceleration to 3 per cent in 2014. Theexpected adoption o the euro on January 1, 2014 will add anestimated 0.2-0.3 percentage points to ination due to hoard-ing ahead o adoption and rounding-o eects, or example inrestaurants and caes.

During the rst three quarters o 2012, year-on-year wage andsalary growth was 3.7 per cent and the rate probably acceler-ated a bit in the nal quarter. Average pay increases growth orthe next two years will remain moderate, at 4.5 and 5.5 per centrespectively. However, growing ination pressure is expected topush up wages and salaries more rapidly in subsequent years.Public sector pay increases will have a growing inuence onthis, although they will be very selective and will be constrainedby budget capacity. State and local government enterpriseswill loosen their belts, which is likely to result in steeper payincreases there.

Last years gradual labour market improvement will con-

tinue. In the ourth quarter o 2012, unemployment increasedby 0.3 percentage points to 13.8 per cent, mainly due to sea-sonal eects. As the economy keeps growing at close to its 4per cent trend rate, demand or labour will continue to increase,although structural unemployment will keep jobless gureshigh or a long time. The situation will continue to vary in di-erent regions o the country, underscoring the need or betterlabour mobility. We expect continued shortages o workers withcertain backgrounds, qualications and specic skills. This willbe true or companies in the manuacturing, inormation tech-nology and construction industries.

With a time lag, economic growth has allowed the bankingsector to stabilise. Following a series o losses over a three-yearperiod, the sector ended 2012 with a prot. The percentage oloans that are overdue remains high, with households being inthe worst nancial condition. O bank loans issued to house-holds, 24.5 per cent were in arrears at the end o 2012, or 4.8percentage points less than in 2011. The total loan portolio obanks continued to decline in 2012, by about one tenth. How-ever, there has been a gradual stabilisation in volume, suppor t-ed by an increase in newly issued loans. This is mainly drivenby business loans, while overall credit demand remains low. Inorder to activate credit demand, there is a need or nationalsupportive mechanisms, or example to help young amilies

make their rst home purchase. In the medium term, corporatelending will continue to dominate, while lending to householdswill remain sot.

Public nances are in a good shape. On December 20 2012, theTreasury repaid its loan principal amount o 493.3 million latsto the International Monetary Fund ahead o schedule, settlingits nancial obligations to the IMF in ull. Latvias remainingdebt to the European Union will be paid on schedule by 2025.Solid economic growth enabled the government to beat budget

decit targets last year. The decit was 1.4 per cent o GDP,compared to an initial target o 1.9 per cent. We orecast thatthe decit will be 1.4 per cent o GDP in 2013 and 0.8 per

cent next year.

Latvia easily complies with all the Maastricht criteria, andthe preparation or a changeover to the euro is under way. Thebudget criterion o a decit not exceeding 3 per cent o GDPwas ullled by a wide margin. In January 2013, 12-month aver-

age ination was 2.0 per cent or well below the criterion o 2.7per cent. In January, long-term yield on government securitiesstood at 4.35 per cent; the criterion was 5.74 per cent. Govern-ment debt in 2012 was well below 60 per cent o GDP: 39.4 percent according to our orecast. Finally, Latvia has been takingpart in ERM II since May 2005.

We expect the European Commission and the European CentralBank to prepare convergence reports on Latvia in April. Thereports will be analysed and, i they are approved, in May theEconomic and Financial Aairs Council (ECOFIN) will inviteLatvia to join the euro zone. In June, the European Council willmake a political decision to the same eect. In July, ECOFIN will

make the nal decision on Latvias accession and set the ex-change rate, which is likely to remain at 0.702804 lats per euro.

Regardless o speculation as to any political motives or sustain-ability considerations behind the euro zone invitation, we aresticking to our view that Latvia will become the 18th mem-

ber o the euro zone in January 2014. As the euro campaigngains strength, popular support or membership is increasing,though slowly so ar. The latest public opinion polls show thatonly 33 per cent o people in Latvia support euro adoption.


11/24

Lithuania


Another year o balanced and decent growth Good competitiveness in exports

Wage growth to accelerate

Ination must be tamed to reach 2015euro target

In 2012, Lithuanias economy continued to grow at a robustpace, supported both by exports and domestic demand. GDProse by 3.6 per cent, which proved to be among the strongestincreases in the European Union. Meanwhile economic imbal-ances were contained, since the trade decit and inationarypressures were rather low.

Exports perormed surprisingly well, especially in thesecond hal, despite the euro zone recession and the slowergrowth o other important trade partners such as Russia andPoland. Robust increases continued or a third straight year astotal exports rose 11 per cent at constant prices, exceeding theirpre-crisis peak level by a actor o 1.3. At the end o the year,exports o agricultural products soared due to a record-highgrain harvest, but export growth was well-diversied.

One o the reasons behind this export success was keepingcosts at a low level. For instance, the increase in nominalwages and salaries stood at just above 2 per cent, which wasmuch less than in peer countries. Real wages have continueddeclining uninterruptedly since early 2009, while the real eec-tive exchange rate declined urther last year.

Meanwhile domestic market growth was relatively sluggish,as reected by a weaker retail recovery and contraction in the

trade decit, especially during the second hal. Wage growthwas too weak to pull private consumption up signicantly, whileuncertainty about the euro zone crisis had a negative eect onwillingness to spend money. In 2013, accelerated wage growth

and rising employment will support consumption, but shrinkingpopulation and cautious behaviour will exert downward pres-sure on it. We expect private consumption to grow by 4 percent in 2013 and 5 per cent in 2014.

The real estate market barely showed positive signs in 2012.According to the EU-harmonised index o home prices, theyrose by a mere o 0.1 per cent in the rst three quarters. Newats went up slightly, while prices o old ats continued to all.Housing supply started gradually rising and the number o

residential building permits grew, suggesting that supply-sideprice pressure will remain limited in 2013 and home prices areunlikely to increase more than 5 per cent. Ater rising in 2011,construction volume shrank again in 2012 or non-residentialbuildings, roads and other inrastructure.

Capital spending remained tight last year due to lingeringuncertainty, which will put a strain on growth potential andproductivity improvement in the medium term. Starting in thesecond quarter o 2012, xed investment has been decliningyear-on-year. Meanwhile capacity utilisation in manuacturingindustry has almost reached its pre-crisis peak. Given attractiveborrowing conditions and the long period o depressed capital

spending, we oresee at least a mild rebound in 2013.

All in all, we see 2013 as another year o balanced modesteconomic growth. Export competitiveness will be challengedby aster wage and salary increases, but the euro zone recov-ery should open up more opportunities in the second hal.Supported by rising consumption and xed investment, GDPgrowth will reach 3.2 per cent in 2013 and 3.5 per cent in

2014. In line with the economys rather balanced development,we expect the current account decit to remain at a modest 3.0per cent o GDP in 2013 and 4.0 per cent o GDP in 2014.

Last year, ination last year ell slightly compared to 2011,

averaging 3.2 per cent. It was still driven by international com-modity prices, while demand-pull orces were largely absent.At the end o 2012, inationary pressures subsided, leading toa 3-month long deationary period. Ination stayed low at thebeginning o 2013, despite a 9-10 per cent increase in regulatedelectricity prices or households and higher excise duties ordiesel uel and tobacco. The secondary eect o the increase inelectricity prices will be limited, since starting in 2013 electric-ity prices or companies are no longer regulated and rms cannegotiate lower prices. We orecast that average annual HICPination will reach 2.5 per cent in 2013 and 2.8 per cent in

2014, driven by global commodity markets and increases

in taxes and regulated prices.

Ater alling 13 per cent in real terms over a our-year period,wages and salaries most likely reached their turning point


12/24


Lithuania

last year. In January 2013, the government increased the mini-mum monthly wage to EUR 290. This alone will add at least 2percentage points to the wage growth rate. Higher-paid em-ployees are also likely to start demanding an increase in orderto restore reasonable wage and salary dierentiation. Moreover,the labour shortage seems to be deepening. In 2012, 43,000

residents let the country. The gure is lower than in 2011 andthe number o returnees is rising, but still this is a signicantloss o labour. Hence, we expect nominal wage growth to accel-erate and exceed ination in 2013. At the same time we expectunemployment to drop urther, rom 13.2 per cent in 2012 to11.5 per cent in 2013 and 10.0 per cent in 2014.

Public nances are on the right track. In the rst three quar-ters o 2012, the general government decit was 2.9 per cent o

GDP. We orecast a scal decit o 2.8 per cent o GDP in 2013and 3.0 per cent in 2014. Central government debt will stabiliseat around a rather comortable 40 per cent o GDP.

In October 2012, Lithuania held a parliamentary election andcentre-let parties were the winners. Four parties the SocialDemocrats, Labour, Order and Justice and Polish Election Ac-tion ormed a government coalition. However, the HomelandUnion-Lithuanian Conservatives, known or their scal consoli-dation eorts, also gathered quite strong support and receiveda quarter o parliament seats. In February 2013, the Labour andOrder and Justice parties declared their intention to merge.This would give the new party one seat more than the currently

leading Social Democratic party.

The new centre-let government has demonstrated more will-ingness to maintain sound scal positions than expected by thenancial markets beore the election. It did not make materialchanges to the budget crated by the previous government.In the context o the euro zone debt crisis, the governmentseems rather likely to stick to budget discipline in the near

uture. The new cabinet also raised the idea o introducing aprogressive personal income tax system, but the implementa-tion o such a system is highly uncertain. Meanwhile the gov-ernments appetite or introducing new VAT exemptions wasmuch more limited than expected beore the election. Only oneexemption, or passenger transport services, was introduced atthe beginning o 2013.

The government also announced that the ofcial euro intro-duction target date or Lithuania is now 2015, one year laterthan the previous governments target. In our opinion, the newtarget can be achieved but it will require political will andprudent decisions. The ination and budget decit criteria willrequire the most attention. Due to weak economic growth in

the euro zone, the Maastricht ination criterion may all urtherto levels that could be difcult to attain without special meas-ures. Meanwhile Lithuanias ination is more sensitive to energyprice uctuations than in Western European countries, due toits heavier weight in the CPI basket.

On the same day as the parliamentary election, Lithuania alsoheld a non-binding reerendum on a new nuclear power plant,in which 65 per cent o the votes came out against construc-

tion. However, the government is continuing its pol itical discus-sions and has not yet made a nal decision about construction.Another important energy project, construction o a liqueednatural gas terminal in Klaipda, is successully under way.The two projects are vital i Lithuania is to increase its energyindependence rom Russia and open up more possibilities orlowering energy prices.

In February 2013, the Bank o Lithuania stopped the activitieso kio bankas, the sixth largest player in the banking market,due to its poor nancial situation. The banks assets were di-vided up, and the good quality assets were bought by iaulibankas, the seventh largest bank in asset portolio terms. In our

view, the impact o these events on government nances andthe banking market will be minimal, while the banking systemas a whole has excess liquidity and capital adequacy.


13/24

Poland


Growth will rebound this autumn ater domestic slump Condence indicators are stabilising

Low ination but no urther rate cuts

Public nances again under control

Polands economy has bottomed out ater an unexpectedlydeep slump in the second hal o 2012. Activity will remainlow in the rst hal, hampered by higher unemployment,continued tight (though less tight) scal policy and weak globaldemand. A gradual acceleration in growth will ollow in thesecond hal. The recovery will be lasting and broad-based.Private consumption will be uelled by a revival in real wagegrowth due to plunging ination. Capital spending will stabilisethis year, partly due to the broad, dramatic downturn in inter-est rates since last autumn. Exports will benet rom improvedGerman demand and Polands good market position.

Due to weakness in late 2012 and early 2013, GDP growth willonly be 1/10 percentage point higher in 2013 than in 2012:

2.1 per cent. It will rise to 3.5 per cent in 2014better butstill below potential growth o some 4 per cent. Our orecasts

or both years are more than hal a percentage point aboveconsensus, a rather optimistic scenario. This is becausePolands economy and banking sector are undamentally quitestrong; once growth begins to rise, we also expect business andhousehold condence to enter an upward spiral. We also ore-see good underlying potential or capital spending.

In 2012, growth plunged rom 3.6 per cent year-on-year in therst quarter to 1.1 per cent in the last, mainly due to a dropin private consumption and cutbacks ollowing a rush

o construction and investment beore the summer 2012European ootball championship, co-hosted with Ukraine. Thisyear began with a stabilisation trend in manuacturing andretail sales, or example. Industrial output rose by 0.3 per cent

year-on-year in January ater alling in December by no lessthan 10.6 per cent. Retail sales rose 2.4 per cent year-on-yearin January ater a 3.6 per cent drop in December. Since autumn,the manuacturing purchasing managers index has been a ewpoints below the growth threshold o 50, but it climbed to 48.9in February. In recent months, retail and construction sectorsentiment indicators have stabilised at low levels. Low con-sumer condence has risen a bit but also remains low.

Export growth stayed high or a long time despite allingexternal demand. But late in 2012 exports slowed sharplyand plunged in December. We predict weak but slightlyhigher export growth in the coming year. Close integrationwith German manuacturers (which have good sales in Asiaand elsewhere) makes an upswing likely, along with a goodcompetitive position as demand rom Western and EasternEurope gradually rises. Every year since 2008, when the globaleconomy was hard pressed, Poland has continued to gainmarket shares, though more slowly in the past three years,

European Commission data show. But looking ahead, exchangerates will not help exports; we expectthe zloty to appreciaterom a stable 4.10-4.20 per euro in the past two months to 3.95in December 2013 and 3.80 in late 2014.

Earlier lively capital spending growth aded rapidly ater theEuropean championship; during the last two quarters o 2012,xed investments ell year-on-year. Greater economic instabil-ity and reduced construction contributed to the downturn.Later this year, capital spending will speed up due to earlierinterest rate cuts. In addition, the government is redoublingits inrastructure spending in 2013 and subsequent years. Inour assessment, there are also pent-up structural investment

needs in the Polish economy ater a long period o relativelylow investment ratios: averaging about 20 per cent o GDPin the past. In light o this, urther EU unds will be welcome.Poland is among the winners in the preliminary agreement


14/24


Poland

on the 2014-2020 EU budget (the rst ever to be smaller thanthe previous one). The country managed to get a 7.5 per centincrease in structural and cohesion unds. These investmentsare expected to take o at a healthy pace in 2014.

Private consumption has gradually lost momentum during thepast year, alling in the nal quarter o 2012 the rst dropsince the introduction o the market economy. Probably themain reason is that households have been squeezed by lowerreal income. Slowing pay increases and high ination well intoautumn led to negative real wage growth during much o 2012.Meanwhile unemployment rose rom 9.6 per cent in 2011 to10.2 per cent in 2012. We expect no rapid labour market im-provement; on the contrary, unemployment will peak at 11 percent in 2013. But this winter, households again saw real wageincreases. The connection between real wages and consump-tion is relatively strong. Falling interest rates will also ease pres-sure on household balance sheets, leading to a slow reboundin credit growth ater the cool-down o the past six months.

Consumption will gradually recuperate in 2013, increasingby 1 per cent this year and 2.5 per cent in 2014.

One potential risk in our consumption orecast, and thus inour GDP orecast, is the historically lowhouseholdsavingsratio: less than 2 per cent in 2012 and only a bit above 2 percent in 2011, down rom 8-9 per cent in 2009-2010. Combinedwith shaky home priceswhich have trended downward in thepast two yearshouseholds may remain hesitant about newpurchases and borrowing or longer than we have anticipated.

A current account decit exceeding 4 per cent o GDP in2010-2011 was one o the ew blemishes in Polands economicundamentals. The country has thus needed to borrow a loto short-term capital. Because o lower imports, the currentaccount decit shrank to about 3.5 per cent o GDP last yearand will end up at a more sustainable ca 3.0 per cent in 2013-2014, easing the pressure o nancing it. But in itsel, the decitis a signal o the need to increase the role o exports.

In 2011 and the rst hal o 2012, stubborn ination o morethan 4 per cent was a dilemma both or households and thecentral bank, with its 2.5 1 per cent target. But since Septem-ber, ination has plunged; it was 1.3 per cent in February. Lowerwage growth and demand, as well as calmer energy and com-modity prices, were behind this shit in the ination trend.We expect ination to remain low this year, given the weak

trends in demand and the labour market. An expected zlotyappreciation will also keep import prices down. Ination willaverage 1.8 per cent in 2013 and 2.5 per cent in 2014.

In November 2012, the central bank changed its monetarypolicy ater an (unnecessary) key interest rate hike in May. Sincethen, it has lowered the key rate rom 4.75 per cent to 3.25 percent, the last cut was a 50 basis point step. The key rate isbelow the 3.5 per cent crisis level prevailing during the

2009-2010 global slump. We predict no urther rate cuts.

Public nances are again under controlater the govern-ment prioritised budget consolidation in recent years. This hasincluded raising retirement ages, abolishing benets or certaingroups and reezing public sector pay. The government wasunder pressure to implement scal tightening, both rom the

European Commission and national public debt ceilings. Dueto austerity and decent growth, the budget decit ell rom 7.9per cent o GDP in 2010 to about 3.5 per cent last year. Theincrease in debt was halted close to the sensitive 55 per centceiling; exceeding it automatically triggers tougher austeritymeasures. Poland has been praised or its scal policy. In Feb-ruary, or example, Fitch raised its outlook or Polands A- creditrating to positive and the European Commission said Poland isone o six EU countries that will probably be removed rom theStability Pact blacklist; its decit exceeded 3 per cent o GDPlast year due to the pension reorm but with public debt below60 per cent o GDP an exception can be made.

Fiscal tightening will now ease gradually, but we predict thatthe budget decit will continue downward to 3.2 per cento GDP this year and 2.8 per cent in 2014. Poland will thusmeet the Maastricht criteria in 2014, but this does not meanthat it wants to switch right away to the euro. Its euro zoneaccession target is politically unclear, although Prime MinisterDonald Tusk has said that Poland will aim at meeting the Maas-tricht criteria as soon as possible (see Theme article). It is alsouncertain whether his centre-right government will actuallyremain in ofce until the next regular election in 2015. It wasre-elected in the autumn o 2011 but has since lost popularityater belt-tightening measures and last years controversial

pension reorm. There are also tensions within Tusks Civic Plat-orm, or example on the issue o allowing registered gay andlesbian partnerships. In January 2013, Parliament once againvoted down a proposal to this eect.


15/24

Russia


Decent growth but weakened potential Bad patch in late 2012 and early 2013

Growth has slowed to around trend rate

Domestic demand has weakened but con-tinued high oil prices sustain growth

Soter monetary policy this autumn

Russias GDP rose by an estimated 2 per cent year-on-year dur-

ing the ourth quarter. This marked the third straight quartero decelerating growth. In 2012 as a whole, growth ended up ataround 3.4 per cent. The slowdown was driven by a clear capitalspending slump, along with a poor harvest that hurt productionin the agricultural sector. Meanwhile household consumption,which has been a undamental driving orce in recent years, hasbegun to weaken. Economic activity cooled somewhat urtherin early 2013. In our judgement, however, oil prices (Brentcrude) will remain close to USD 110 per barrel during both

2013 and 2014, providing stable export and tax revenues andthus also helping sustain growth. We expect GDP to increaseby 3.0 per cent in 2013 and by 3.5 per cent in 2014.

Growth now close to trendAlthough growth has clearly slowed, unemployment is very lowin historical terms, while capacity utilisation is high. This moremoderate growth rate is thereore structural, and the economyis now growing at close to its trend rate, which we estimateat around 3 per cent. In recent years, growth has not rebound-ed to the levels o around 7 per cent that prevailed beore the2008-2009 nancial crisis.

As we have indicated in earlier reports, our assessment is thatextensive reorms will be needed to enable growth to

reach the goal o 5-6 per cent set by President Vladimir

Putin. Russia has taken steps in this direction, among otherthings by joining the World Trade Organisation last year, adopt-ing a new budget rule, introducing an ination target and ap-proving an ambitious privatisation programme targeting USD10-15 billion in asset sales per year or the next three years lastSeptember. Much remains to be done. The Russian economy isstill highly vulnerable to oil price declines and the central gov-ernment still has too much inuence on the economy, while thebusiness climate is poor. Demography is also lowering econom-ic growth because o continued population decline.

Given current relatively high oil price levels, the well-knownproblem o low reorm appetite will unortunately persist. Thisis worsened by the lack o challenges to the current politi-cal structure (see box, page 18 ). Without more ar-reachingreorms, there is a risk that growth will get stuck at around 3-4

per cent. A drop in oil prices would mean even slower growth.Because o the great importance o oil prices to exports, pricechanges have a clear impact on the economy. Oil accountsor around 60 per cent o total exports. During 2012, oil priceswere around USD 110/barrel, measured as a ull-year average,and thus at about the same level as in 2011. Although theyconsequently provided no extra push to growth, oil prices stillhelp to sustain economic activity. Meanwhile export growthdecelerated sharply in 2012, hovering at around zero year-on-year during the second hal. Our orecast is that oil prices willremain around USD 110/barrel in both 2013 and 2014, whichis in line with the consensus among orecasters. Oil prices will

thus continue to provide some support to growth. Exports willbe stimulated as global economic growth continues to improve.We expect Russias export volume growth to accelerate duringthe second hal o 2013 and early in 2014.


16/24


Russia

Weak beginning o 2013Most economic indicators show a sluggish start to 2013. The

composite purchasing managers index (PMI) has beenrather at in recent months but remains above the expan-

sion threshold o 50. Although the service sector PMI is stillsignicantly higher than the manuacturing PMI, it has recentlyallen. This supports the picture o a cool-down in domesticdemand. Consumer condence is also showing the same pic-ture. From a relatively high level, condence slipped during thesecond hal o 2012. This downturn is expected to continueduring the current quarter as household consumption slows.

Both capital spending and industrial output have been weakin recent months. In January, industrial production measuredyear-on-year ell or the rst time since 2009 and the decreasecontinued in February. Capital spending decelerated clearlyduring 2012, and this weak perormance is expected to con-tinue in the next ew months, driven by base eects. In January,xed investments rose by 1.1 per cent year-on-year. Looking abit urther ahead, however, there are signs o greater strength.In the run-up to the Winter Olympics in Sochi next year and theootball World Cup in 2018, there is a great need or inrastruc-ture investments. The governments explicit ambition to de-velop the eastern part o the country also mean that extensiveinrastructure investments will be needed in the coming years.

Retail sales have slackened. Measured year-on-year, salesadmittedly rose by a decent 3.5 per cent in January, but this

increase is well below the rate o around 7 per cent during therst hal o 2012. This slowdown has taken place even thoughunemployment has been at a historically low level. Nominalwages and salaries have continued to climb by more than 10per cent year-on-year, but rising ination has led to a slowerincrease in real wages during the past ew months. Increased

household saving as well as slightly more restrictive lendinghave probably also contributed to the weakening o retail sales.

Lending growth will slowIn recent years, credit-led household consumption has beenan important driving orce behind Russian economic growth.Lending to households increased by about 40 per cent in 2012.The central bank has expressed concern and has already takensteps to slow the increase, yet our assessment is that the risksare limited in the longer term. The credit increase is occurringrom a very low level. The ratio o household debt to GDP isaround 10-12 per cent, compared to around 30 per cent orother economies in the region.

As the economy decelerates, we also expect credit growth toslow. Russian banks also seem determined to ollow the centralbanks request that lending to households should not expandby more than 30 per cent during 2013. Furthermore, total lend-ingwhich includes loans to companieshas already begunto cool measured year-on-year. Although slower lending growthand economic activity are now putting pressure on the banks,their prospects look brighter in a slightly longer perspective.Large capital spending needs will generate good uture de-mand or loans.

Ination close to peakingSince the very low levels o spring 2012, the ination rate hassurged. The upturn has been driven primarily by rising oodprices, but ee hikes that were delayed due to the elections olate 2011 and early 2012 have also contributed. Ater a stabili-sation late in 2012, ination regained momentum and reached7.3 per cent in February: clearly above the central banks 5-6per cent target. However, we believe that ination is closeto peaking. Food price ination is beginning to stabilise andthe government is expected to carry out smaller new ee hikes

than announced earlier. We believe that ination will all in thesecond hal o 2013, mainly driven by base eects rom oodprices, but we anticipate no sharp decline. Core ination has


17/24


Russia

stubbornly remained at just below 6 per cent in recent months,despite the cool-down in economic activity. This underscoresthat slower growth is largely structural, and we thus do notexpect weaker growth during 2013 to result in any major dropin ination. As annual averages, ination will end up at 6.3per cent in 2013 and 5.2 per cent in 2014.

Central bank in a tricky situationInation well above target, combined with alling growth, hasput the central bank in a tricky situation. Government leadershave clearly called or looser monetary policy in order to stimu-late the economy. Uncertainty about monetary policy is beingreinorced because the current central bank governor, Ser-gei Ignatiev, is being replaced by presidential economic

advisor Elvira Nabiullina when his term expires in June. The

choice o central bank governor, announced early in March,

will impact the direction o uture monetary policy. Nabiullinawas an unexpected choice and her name was not among thosementioned beore the announcement. Since then, there hasbeen increased concern that the independence o the centralbank may weaken and that she will pursue a more expansion-ary monetary policy, in line with government wishes.

Since the latest key interest rate hike in September 2012, therate has remained at 8.25 per cent. Februarys accelerated ina-tion rate has reduced the probability o a rate cut in the nearuture. The key rate is expected to remain unchanged duringthe next ew months. When ination alls later in 2013, how-ever, this will make some room or rate cuts. Our assessmentis that the key interest rate will be cut by 50 basis pointsduring the second hal and will thus stand at 7.75 per cent atthe end o 2013.

During the 2008-2009 nancial crisis, the rouble lost nearly athird o its value against the USD/EUR basket (55 per cent USD

and 45 per cent EUR). Despite a recovery since then, the roubleis currently about 15 per cent below its pre-crisis level. During2013, there are several actors pointing towards a rouble ap-preciation. Ater the introduction o the Euroclear system, it hasbecome easier or oreign investors to buy Russian governmentbonds, which is generating an inow o oreign currencies. Therouble is also being supported by a continued current accountsurplus. Additional actors are continued high oil prices and theact that large-scale currency outows are expected to deceler-ate due to an easing o political uncertainty. We thus expectthe rouble to appreciate by around 4 per centand to standat 33.8against the USD/EUR basket by the end o 2013. Theexchange rate will continue to become more exible through

Tough oreign policy stance gives Putin supportor his domestic policiesIn recent years, Russia has adopted a more orceul oreignpolicy stance, especially towards the United States but alsotowards neighbouring countries. Relations with Ukraineremain complicated. Ukraine has tried to renegotiate itsimport agreement or Russian natural gas in an attempt topush down prices, but Russia has responded with a call orUkraine to join the Russian-led CIS customs union, which alsoincludes Belarus and Kazakhstan. Russia is thus trying to tie

Ukraine closer; participation in the customs union would cre-ate obstacles in the path o Ukraines ambition to expand itscooperation with the EU instead.

Meanwhile Russias relations with the US remain rosty. Themain reason is Russias veto o United Nations-led sanc-tions against Syria. The so-called Magnitsky Act, which wentinto eect last December and prevents selected high-levelRussian ofcials rom entering the US and using Americanbanks, has also contributed to greater tensions between thecountries. Russia, in turn, has responded with its own list ohigh-level American ofcials and has prohibited US adoptionso Russian children.

President Vladimir Putins unwillingness to cooperate withthe US and his tough oreign policy stance have strengthenedhis position, against the backdrop o a trend towards growing

domestic political protests in recent years. Although Putinspopular support ell rom more than 70 per cent early in 2011,it has rebounded somewhat in recent months and is nowaround two thirds. The percentage o people who state thatthey would vote or Putin in the next presidential election hasalso declined, but in the absence o a person with enoughcharisma to challenge himcombined with a ragmentedoppositionat present there are no major risks to the politi-cal structure. Suggested changes in the system o electionsto the Duma (lower house o Parliament) that are likely to beimplemented will also probably benet Putins United Russiaparty. Since both the next Duma election (late 2016) and thenext presidential election (2018) are ar in the uture, politicaluncertainty is currently limited. We thus do not expect anyextensive changes in economic policy either.

In a longer perspective, however, there is potential or politi-cal upheaval. Public opinion surveys show that around 50per cent o the population would preer an economic systembased on central planning. The ormer Soviet political systemalso enjoys sizeable support. Such sentiments create the

basic prerequisites or the Communist Party, which currentlyholds about 20 per cent o the seats in the Duma, to radicallyboost its support under a charismatic leader.


18/24


Russia

a gradual indrease in the current band o +/- 10 per cent. As aresult interest rates will become less volatile, acilitating eco-nomic planning. The currencys real eective exchange rate hasstrengthened greatly since last autumn, which now risks under-mining Russias competitiveness.

Fiscal policy will become less expansionaryThe objective o the ederal government budget or 2013-2015,unveiled last October, is a signicantly less expansionary s-cal policy in the years ahead. This restraint will mainly apply toexpenditures. A new budget rule has been introduced in orderto hold back spending. According to this rule, expenditures maynot exceed revenues by more than 1 per cent o GDP, calculatedon the basis o average oil prices during the preceding veyears. In order to orecast ederal budget revenues, expected oilprices are used. Since income rom the oil and gas sector ac-counts or around hal o ederal revenue, all budget orecastswill be very sensitive to oil price changes.

Any ederal budget surplus is directed into two governmentunds: the Reserve Fund and the National Wealth Fund (NWF).The surplus goes rst to the Reserve Fund, but i this undexceeds 7 per cent o GDP the money goes instead to the NWF.The reserve und may, in turn, be used to cover a budget decitwhile the NWF serves as a back-up to the pension system.

The governments orecast is that the budget will move roma modest decit o just below 1 per cent o GDP this year tobalance in 2015, but we believe that the budget is based onexcessively optimistic GDP growth orecasts. The governmentis expecting growth to reach about 4-5 per cent a year, whichis signicantly higher than our orecasts. It will also be toughto keep expenditures down. During the presidential electioncampaign last spring, President Putin promised to increasepublic expenditures, among other things by boosting deenceappropriations and public sector pay. The preparations or the2014 Winter Olympics in Sochi wil l also require increased ex-penditures. Meanwhile the economic deceleration is leading tocalls or more expansionary policies. Our assessment is that thebudget decit will exceed the government orecast. The decitwill end up at 0.5 per cent o GDP in 2013 but then rise to

around 1 per cent in 2014.

Although the new budget rule and the governments ambitionto pursue a less expansionary scal policy are steps in the right

direction, in a somewhat longer perspective Russian govern-ment nances will remain dependent on three-digit oil prices.Adjusted or oil-related revenue, the budget decit is an esti-mated 10 per cent o GDP according to the government, andthe budget is balanced when oil prices are slightly below USD120/barrel. Since ederal government debt is an extremely low

10 per cent o GDP, however, there is no acute threat. Furtherahead, though, we oresee a weakening o the current accountbalance, driven by imports o capital goods consistent withthe expected increase in capital spending. The current accountbalance is also highly dependent on continued high oil prices. Aprice drop thus risks leading to a situation o both budget andcurrent account decits. A weakening in the current accountbalance is especially serious in light o continued large-scalecapital outows. Although they have recently slowed, theseoutows are still extensive and weaken Russias current ac-count position.


19/24

Ukraine


Difcult policy decisions continued weak growth A devaluation is approaching

An IMF agreement would be the best alter-native but is ar rom certain

Continued political balancing act betweenthe European Union and Russia

The economy perormed very weakly in the second hal o 2012and growth decelerated sharply. Year-on-year, growth wasnegative in the third and ourth quarters. Full-year 2012 growthreached 0.2 per cent: a dramatic slowdown compared to 5.1per cent in 2011. Domestic demand held up decently in 2012but will weaken this year. Nor is external demand expected toprovide much support; exports will continue to be depressed byweak growth in Europe and subdued demand or steel.

Aside rom its clear deceleration, the economy risks an evendeeper crisis. The main problem is the large current accountdecit and resulting downward pressure on the currency. Weare sticking to our assessment that the hryvnia will be deval-ued. Even i the right policy decisions are made and Ukrainedodges a severe crisis, growth will still be very weak. GDP willremain unchanged in 2013 ollowed by a weak rebound o

1.8per cent in 2014; clearly below the consensus orecast.

The government must quickly make several difcult decisionsin order to reduce the risk o the economy being pulled into amajor crisis. The Party o Regions managed to hang on to itsparliamentary majority by a narrow margin ater the late Octo-ber election. This has reduced political uncertainty. With three

years until the next (presidential) election, there is a window orimplementing unpopular reorms such as cutting gas subsidies.

The toughest issue is currency policy. Last autumn the hryvniawas squeezed by a big current account decit and speculationabout devaluation. The Ukrainian state must also pay backsome USD 9.6 billion in oreign loans, including a large repay-ment to the IMF. Furthermore, the private sector has a relativelylarge oreign debt with short maturity. Although the govern-ments debt is a low 40 per cent o GDP, it thus has a largeshort-term external unding requirement. To ease pressureagainst the currency, in November 2012 the government en-acted a law orcing exporters and private individuals to convert

oreign currency earnings into hrynvia. This helped uel ap-preciation late in 2012, but in 2013 the currency has weakenedagain: by about 1 per cent against the USD. Since mid-2011 thecurrency reserve has allen by more than a third. It is now belownormally critical thresholds. As the currency reserve shrinks,the risk o an uncontrolled evaluation increases. In Decem-ber, both Moodys and S&P also lowered Ukraines credit ratingto B3 and B, respectively.

The pressure on the hryvnia could be eased by a new stand-by agreement with the International Monetary Fund. Ukrainesigned an IMF agreement in the summer o 2010 but it wasrozen in spring 2011 and expired in December 2012. Duringthe rst hal o February, an IMF delegation visited Ukraineto assess the potential or a new stand-by agreement. Theobstacles to an agreement are well known rom earlier. Theyare related to Ukraines large gas price subsidies to householdsand businesses, budget decits (around 3 per cent o GDP in2012), calls or a more exible exchange rate and the solvencyo the banking system. In our judgement, a new agreementIMF would be the best alternative or Ukraine and this is

also our main scenario. It would create stability and reduceuncertainty, thus laying the groundwork or a lasting recovery.But an agreement is ar rom certain. The risk is that Ukrainewill abstain rom an agreement to avoid the IMFs politically


20/24


Ukraine

unpleasant reorm requirements and instead try to resolve thesituation on its own via international borrowing. But this is ahigh risk scenario, in which Ukraine at worst might be shut outo international capital markets. This would make it ar moredifcult to meet the countrys external unding requirement.

Regardless o whether Ukraine signs an IMF agreement, ourassessment is that it will devalue the hryvnia. The question iswhether this will be controlled or uncontrolled. We are stick-ing with our earlier assessment that the devaluation againstthe USD will be at least 10 per cent. We expect it to occurtoward the end o the second quarter o 2013. A devaluationwould stop the erosion o the currency reserve, thanks to areduced need or the central bank to intervene in order to keepthe exchange rate stable at around UAH 8 per USD, but wouldmeanwhile have various negative eects, such as higher import

prices and thus a rising ination rate as well as higher oreigndebt costs.

The current account decit rose to more than 8 per cent oGDP in 2012, driven by a growing trade decit. No signicantimprovement in the trade balance is likely. Exports continueto be depressed by weak international demand or steel, risingby a mere 0.6 per cent year-on-year in December. We expectthe current account decit to decrease to 6.0 per cent o GDPin 2013. Devaluation is expected to have only a limited impacton exports, due to weak demand. It is thus uncertain whetherit would have any major positive eect on the current accountbalance.

Domestic demand will provide only limited support to

growth. Industrial output remains anaemic; in January it ellby 3.2 per cent compared to the same month o 2012. Theconstruction sector is also perorming weakly. One bright spotis retail sales, which have continued to grow by around 10 percent year-on-year in recent months. This trend is being drivenby good real wage increases due to non-existent ination. De-valuation would hit households hard, though, since more thanone third o their borrowing is in oreign currencies. The bank-ing sector as a whole is squeezed by Ukraines problems withunding its current account decit, and lending remains weak.

From the summer o 2011 until mid-2012 the ination rate ellsharply, driven by lower ood prices (around 50 per cent o theCPI basket consists o ood) and base eects. Since last spring,

the ination rate has been close to zero; in January it was -0.5per cent. Core ination is also staying close to zero. But lookingahead, the ination rate is expected to rise, driven by increasingood prices as a result o the poor 2012 harvest. The expecteddevaluation will push up import prices. Together with highergas prices and base eects, this will help uel a rising ination

rate. We expect ination to reach 5.5 per cent in 2013 and6.5 per cent in 2014.

Relations with both the EU and Russia remain tense. In 2011Ukraine signed a trade and integration pact with the EU; a reetrade agreement is one key element. This agreement has beenon the back burner or more than a year, since Brussels is in-creasingly concerned about the state o democracy in Ukraine.This is connected, above all, to the governments treatment oormer Prime Minister Julia Timoshenko but also to criticism o

last years parliamentary election. President Viktor Yanukovichhas said deeper relations with the EU are a priority, and a largeshare o the population also supports such a development.

I rapprochement with the EU progresses no urther, an alterna-tive or Ukraine is to draw closer to Russia. Such a developmentseems less likely, however; relations are wracked by tensionsconnected to Ukraines natural gas imports. In late January,Russia demanded USD 7 billion rom the Ukrainian state gascompany Natogaz as compensation because Ukraine hadimported too l ittle gas in 2012, thereby breaching currentagreements. The gas dispute is expected to continue, althoughUkraines ambition is to reduce its dependence on Russian gas(see box). The most likely scenario is thus that Ukraine willprioritise its ambition to expand its ties with the EU, while

trying to preserve good relations with Russia.

Reducing Ukraines dependence on Russian gasIn late January 2013, the Ukrainian government signed anagreement with Royal Dutch Shell on gas extraction andproduction in Ukraine. The deal may potentially be worthmore than USD 10 billion and is the rst step in Ukrainesambition to develop its own gas reserves, thus reducing itsdependence on Russian gas. The agreement is mainly aboutdeveloping shale gas deposits and, as in the US, radically

boosting domestic energy production. Ukraine is believed tohave Europes third largest shale gas deposits, but it will taketime beore the agreement has an impact; the governmentsambition is to cover domestic gas needs within ten years.


21/24

Key economic data


ESTONIA 2007 2008 2009 2010 2011 2012() 2013() 2014()GDP, % 7.5 -4.2 -14.1 3.3 8.3 3.2 3.8 3.7Ination, HICP, average, % 6.6 10.4 -0.1 3.0 5.0 3.9 3.3 3.3Unemployment, % 4.6 5.5 13.8 16.9 12.5 10.2 9.8 9.7Current account, % o GDP -15.9 -9.2 3.4 2.9 2.1 -1.2 -0.3 1.3Public sector nancial balance,% o GDP 2.4 -2.9 -2.0 0.2 1.1 -1.0 -0.7 0.0Public sector debt, % o GDP 3.7 4.5 7.2 6.7 6.1 10.5 12.0 11.73-month interest rate, end o period 7.2 7.8 3.3 1.1 1.4 0.2 0.4 0.6

LATVIA

2007 2008 2009 2010 2011 2012() 2013() 2014()GDP, % 9.6 -3.3 -17.7 -0.9 5.5 5.5 3.8 5.0Ination, HICP, average, % 10.1 15.3 3.3 -1.2 4.2 2.3 1.4 3.0Unemployment, % 6.1 7.5 16.9 18.7 16.2 14.9 13.3 12.2Current account, % o GDP -22.4 -13.1 8.6 3.0 -1.2 -1.7 -2.4 -3.0Public sector nancial balance,

% o GDP -0.4 -4.2 -9.7 -8.1 -3.4 -1.4 -1.4 -0.8Public sector debt, % o GDP 9.0 19.8 36.7 44.5 42.2 39.4 36.7 35.4EUR/LVL, end o period 0.7 0.7 0.7 0.7 0.7 0.7 0.7 -Key rate, eop 6.5 6.0 4.0 3.5 3.5 2.5 0.75 0.75

LITHUANIA

2007 2008 2009 2010 2011 2012() 2013() 2014()GDP, % 9.8 2.9 -14.8 1.5 5.9 3.6 3.2 3.5Ination, HICP, average, % 5.8 11.1 4.2 1.2 4.1 3.2 2.5 2.8Unemployment, % 4.3 5.8 13.7 17.8 15.3 13.2 11.5 10.0Current account, % o GDP -14.5 -12.9 3.7 0.1 -3.7 -2.0 -3.0 -4.0Public sector nancial balance,% o GDP -1.0 -3.3 -9.4 -7.2 -5.5 -3.0 -2.8 -3.0Public sector debt, % o GDP 16.8 15.5 29.4 38.0 38.5 40.0 40.0 40.0EUR/LTL, end o period 3.45 3.45 3.45 3.45 3.45 3.45 3.45 3.453-month interest rate, eop 6.65 9.89 3.90 1.50 1.66 0.68 0.80 0.905-year government bond, eop 4.80 13.10 6.60 4.60 5.40 2.40 2.60 2.80

() = orecast


22/24


Key economic data

POLAND

2007 2008 2009 2010 2011 2012() 2013() 2014()GDP, % 6.8 5.1 1.6 3.9 4.3 2.0 2.1 3.5Ination, HICP, average, % 2.6 4.2 4.0 2.7 3.9 3.7 1.8 2.5Unemployment, % 9.6 7.1 8.1 9.6 9.6 10.2 11.0 10.8Current account, % o GDP -6.2 -6.6 -3.1 -4.3 -4.5 -3.6 -2.9 -3.2Public sector nancial balance,% o GDP -1.9 -3.7 -7.4 -7.9 -5.0 -3.5 -3.2 -2.8Public sector debt, % o GDP 45.0 47.1 50.9 54.8 56.4 55.8 54.0 54.0EUR/PLN, end o period 3.6 4.1 4.1 4.0 4.5 4.1 4.0 3.8Key rate, eop 5.25 4.00 3.50 3.75 4.50 4.25 3.25 3.755-year government bond, eop 6.13 5.34 5.91 5.52 5.34 3.21 3.60 4.20

RUSSIA

2007 2008 2009 2010 2011 2012() 2013() 2014()GDP, % 8.5 5.2 -7.8 4.3 4.3 3.4 3.0 3.5Ination, average % 9.0 14.1 11.7 6.8 8.5 5.1 6.3 5.2Unemployment, % 6.5 6.2 8.4 7.5 6.6 5.7 5.6 5.3

Current account, % o GDP 5.9 6.1 4.0 4.8 5.3 4.3 3.1 2.2Public sector nancial balance, % o GDP 6.8 4.9 -6.3 -3.5 1.6 0.8 -0.5 -1.0Public sector debt, % o GDP 8.7 6.6 10.2 11.6 11.6 11.9 12.3 12.6USD/RUB, end o period 24.58 29.57 30.10 30.50 32.08 30.36 30.50 30.30Rouble vs. euro/dollar basket, eop 29.7 34.8 36.0 35.2 36.4 34.7 33.8 33.0

UKRAINE 2007 2008 2009 2010 2011 2012() 2013() 2014()GDP, % 7.9 2.3 -14.8 4.1 5.1 0.2 0.0 1.8Ination, average, % 12.8 25.2 16.0 9.4 8.0 0.6 5.5 6.5Unemployment, % 6.4 6.4 8.8 8.1 8.5 7.8 8.2 8.4Current account, % o GDP -3.7 -7.1 -1.5 -2.2 -5.6 -8.4 -6.0 -5.0Public sector nancial balance,% o GDP -2.0 -3.2 -6.3 -5.7 -2.7 -3.0 -3.1 -2.5Public sector debt, % o GDP 12.3 20.5 35.4 40.1 36.5 36.0 36.4 35.8USD/UAH, end o period 5.05 7.80 8.00 7.97 8.00 8.04 9.20 9.50

() = orecast


23/24


Economic Research available on InternetEastern European Outlookpublished by SEB Economic Research is available on the Internet at: www.sebgroup.com. This page isopen to all.

To get access to all other research and trading recommendations or Merchant Bankings customers on the Internet at www.mb.se,a password is needed that is exclusive to these clients. I you wish to get access to this web site, please contact Merchant Banking to

receive the password..

This report has been compiled by SEB Merchant Banking, a division within Skandinaviska Enskilda Banken AB (publ) (SEB) to provide background inorma-

tion only.

Opinions, projections and estimates contained in this report represent the authors present opinion and are subject to change without notice. Although inor-mation contained in this report has been compiled in good aith rom sources believed to be reliable, no representation or warranty, expressed or implied, is

made with respect to its correctness, completeness or accuracy o the contents, and the inormation is not to be relied upon as authoritative. To the extent

permitted by law, SEB accepts no liability whatsoever or any direct or consequential loss arising rom use o this document or its contents.

The analysis and valuations, projections and orecasts contained in this report are based on a number o assumptions and estimates and are subject to con-

tingencies and uncertainties; dierent assumptions could result in materially dierent results. The inclusion o any such valuations, projections and orecasts

in this report should not be regarded as a representation or warranty by o

Eastern European Outlook 1303: Continued decent growth in North-eastern Europe

Documents