Emerging Europe Central Banking: What To Expect In 2014

BMI View: Amidst clear signs of a domestic demand recovery, monetary authorities in central Europe will face a delicate balancing act in 2014 as they seek to support growth, unwind unprecedented loose policy, and contain incipient inflationary pressures. Turkey and Russia, on the other hand, will face weakening growth prospects and still-elevated inflation.

Following a year in which interest rates in emerging Europe were cut to historic lows to stimulate weak domestic demand and defend against unwanted currency appreciation, we expect loose monetary policy to persist through much of 2014. With the exception of Turkey, emerging European financial markets were relatively unscathed by rising US Treasury yields in 2013 when compared to emerging market peers in Latin America and Asia ( see 'Central European Banks Look Strongest' January 16), and instead remain tightly integrated with western European markets, where falling inflation and the prospect of further monetary easing has kept a lid on borrowing costs.

Therefore, idiosyncratic trajectories of consumer price inflation and domestic demand growth will determine the course of monetary policy in the region in 2014. In Poland and the Czech Republic, where we believe the rate cutting cycle has already come to end, monetary authorities will face a delicate balance between countering the build-up of demand-side price pressures and supporting nascent economic recoveries. In contrast, benign inflation dynamics will provide scope for further rate cuts in Hungary and Romania, although both countries remain the most vulnerable to FX depreciation and a rapid rise in headline price growth. Turkey and Russia face a unique set of challenges, and the former will struggle to avoid stagflation in 2014 as growth slows and core inflation rises.

Not Following USTs Higher
US & Central Europe Benchmark 10-Year Local Currency Bond Yield, %, rebased to Jan-2013=100

Emerging Europe Central Banking: What To Expect In 2014

BMI View: Amidst clear signs of a domestic demand recovery, monetary authorities in central Europe will face a delicate balancing act in 2014 as they seek to support growth, unwind unprecedented loose policy, and contain incipient inflationary pressures. Turkey and Russia, on the other hand, will face weakening growth prospects and still-elevated inflation.

Following a year in which interest rates in emerging Europe were cut to historic lows to stimulate weak domestic demand and defend against unwanted currency appreciation, we expect loose monetary policy to persist through much of 2014. With the exception of Turkey, emerging European financial markets were relatively unscathed by rising US Treasury yields in 2013 when compared to emerging market peers in Latin America and Asia ( see 'Central European Banks Look Strongest' January 16), and instead remain tightly integrated with western European markets, where falling inflation and the prospect of further monetary easing has kept a lid on borrowing costs.

Not Following USTs Higher
US & Central Europe Benchmark 10-Year Local Currency Bond Yield, %, rebased to Jan-2013=100

Therefore, idiosyncratic trajectories of consumer price inflation and domestic demand growth will determine the course of monetary policy in the region in 2014. In Poland and the Czech Republic, where we believe the rate cutting cycle has already come to end, monetary authorities will face a delicate balance between countering the build-up of demand-side price pressures and supporting nascent economic recoveries. In contrast, benign inflation dynamics will provide scope for further rate cuts in Hungary and Romania, although both countries remain the most vulnerable to FX depreciation and a rapid rise in headline price growth. Turkey and Russia face a unique set of challenges, and the former will struggle to avoid stagflation in 2014 as growth slows and core inflation rises.

Central Europe: Inflationary Pressures Lurking

One common theme among central European economies in 2013 was a strong disinflationary trend. However, we believe that this was primarily a supply-side phenomenon, and with high frequency indicators pointing to a broad-based acceleration of domestic demand, for now see depressed price growth supporting the ongoing recovery in private consumption. This implies that central banks will have to remain vigilant to prevent unprecedented domestic monetary easing from leading to a rapid increase in consumer prices by end-2014.

Czech Republic: The Czech Republic has faced a deeper recession and more protracted recovery than Central European peers, and we thus do not expect a change to the Czech National Bank's (CNB) monetary policy stance in 2014. With policy rates near-zero since Q412, the CNB for the first time resorted to direct intervention in the FX market to combat disinflationary pressures in November 2013, targeting a level of CZK27.00/EUR. In line with CNB guidance, we expect FX intervention to continue throughout 2014, with the main risk to our outlook being that inflation normalises earlier than expected. Although core inflation remains weak, headline consumer price growth reached 1.4% y-o-y in December, within the central bank's target band of 1-3%. With accelerating credit and retail sales growth pointing to an improving outlook for domestic demand, we cannot rule out the CNB abandoning its FX target at some juncture in 2014.

Czech Recovery Lags Poland
Czech Republic And Poland - Retail Sales Volume, % chg y-o-y, 3mma

Poland: The National Bank of Poland (NBP) has followed the lead of developed state policy makers in employing forward guidance, pledging to maintain its reference rate at a historic low of 2.50% at least through H114. However, we expect the NBP to hike rates from a current level of 2.50% to 3.00% in Q414 as demand-pull price pressures build. With credit demand already weak, It is our view that low policy rates in Poland have further inhibited bank lending by depressing lenders' net interest margins ( see 'An Increasingly Positive Outlook For Banking Sector', November 20), and believe that rising borrowing costs could actually encourage banks to lend and prove to be a net positive for the growth outlook.

Hungary: Although we forecast the Hungarian National Bank (MNB) to raise its policy rate to 3.50% by end-2014, from 2.85% at the time of writing, we do not believe it has yet reached the end of its rate cutting cycle. Government mandated utility price cuts have seen headline inflation fall to 0.4% y-o-y in December 2013, providing scope for further monetary easing in H114. However, we believe that supply-side factors mask relatively robust underlying price pressures (core inflation was 3.5% y-o-y in December) that will become apparent as base effects wear off in the latter stages of 2014, at which point we expect the MNB to reverse its multi-year easing cycle.

Headline Rate Masks Inflationary Pressures
Hungary - Headline And Core Inflation, % chg y-o-y

Although the HNB's monetary policy stance appears appropriate when considering the rate of credit contraction still underway in the banking sector, we believe this is due in large part to asset quality deterioration and policy uncertainty limiting the supply of credit. As the country's economic recovery appears well underway, we believe that further rate cuts pose more potential risks than benefits given a high level of FX-denominated private sector debt and foreign ownership in the local debt market. The MNB's aggressive easing cycle has the potential to depress demand for Hungarian assets, leading to a significant rise in government borrowing costs and depreciation of the forint, a prospect made more likely by rising US yields.

Romania: Like in Hungary, core inflation in Romania remains well clear of deflationary territory and indicates stable demand-pull price pressures. However, Romania has seen a dramatic and sustained decline in headline inflation since Q411 and we expect supply-side factors, in particular food prices, to see headline consumer price growth ease further in 2014. The ongoing contraction of bank lending will provide addition impetus for further monetary easing, and we expect the central bank to cut rates to 3.50% by end-2014, from a current level of 4.00%. As with Hungary, high levels of FX-denominated private debt leave households vulnerable to local currency depreciation. However, we have grown increasingly bullish on Romania's macroeconomic fundamentals and believe the country's improving growth story will underpin investor sentiment and financial stability.

Turkey And Russia: Slowing Growth And High Inflation Complicate Policy

Russia: The Central Bank of Russia (CBR) is transitioning from a managed exchange rate regime to a free float in 2014, which given our bearish long-term view on Russian growth and expectation for further domestic monetary easing, informs our expectation for steady rouble depreciation ahead. Through much of 2013, we were surprised by the relatively hawkish stance adopted by the CBR, making inflation its top priority despite a sharp slowdown in economic activity. We expect a gradual shift towards supporting growth in 2014 as government mandated utility price cuts will see inflation fall further, providing the CBR with room to cut rates to 5.25% by the end-2014. Although our expectation for steady currency depreciation implies upward pressure on consumer prices through exchange rate pass-through effects, we believe that domestic demand weakness will remain the primary driver of benign inflation dynamics.

Price Stability To Outweigh Political Pressure
Turkey - TRY/US$ Exchange Rate & Core Inflation, % chg y-o-y

Turkey: Turkey remains emerging Europe's most vulnerable country to rising US yields due to its massive current account deficit and short-term external financing requirement, and the CBRT has raised its overnight lending rate twice since July 2013 in an effort to bolster demand for Turkish assets and stem the lira's depreciation. However, despite an atmosphere of political infighting ( see 'Major Implications Of AKP Rift', December 19) that has accelerated the depreciatory pressure on the currency since mid-December, the issue of interest rates and monetary policy has become increasingly politicised, with the CBRT facing intense pressure not to hike further. Although elevated political uncertainty, falling confidence and rising borrowing costs will see growth slow in 2014, the CBRT's main concern will be elevated inflation, given our expectation for continued lira weakness and a historically tight inverse correlation between core inflation and the trajectory of the currency. However, we continue to believe that despite political considerations, the CBRT will hike further in 2014 as the outlook for price growth deteriorates.

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