BMI View: If the ECB does opt to enact large scale asset purchases, export-driven Central European economies would adopt activist monetary policy stances to mitigate FX appreciation, whereas Russia and Turkey may stand to benefit from ECB quantitative easing.
Real GDP readings for the first quarter of 2014 indicate that the eurozone recovery is failing to achieve escape velocity, while euro area HICP remains close to zero, increasing the pressure on the European Central Bank (ECB) to loosen monetary policy to ward off the deflationary threat. While the ECB has relied on 'verbal intervention' to soften the euro in recent months, the effectiveness of this appears to be fading with the euro failing to drop significantly below EUR1.37/USD in recent months, increasing the probability that the ECB will need to take hard action in the near future.
We emphasise that we still believe any form of quantitative easing (QE) by the ECB (in the form of large-scale asset purchases of sovereign bonds) to be some way off, as considerable technical obstacles remain in place. Our core view remains that the ECB's actions will probably disappoint financial markets in their scope. Nonetheless, given the distortive impact that major central bank policies can have on regional emerging market economies, it seems prudent to examine the potential impact that unconventional monetary policy might have on emerging European economies.
Under our hypothetical QE scenario, we are working on the assumption that the ECB would embark on a large-scale asset purchase programme of sovereign bonds, which would impact on emerging European economies via two main channels. First, a major expansion of the ECB's balance sheet, while the Federal Reserve is simultaneously reducing the pace of its expansion, would weaken the euro. Second, ECB sovereign bond purchases would probably drive down sovereign spreads across the euro area, in turn triggering a new 'hunt for yield' as euro area spreads become increasingly marginal. Emerging European countries would probably experience a sharp rise in capital inflows into local debt markets, as they did in 2012/2013. A combination of a larger ECB balance sheet and a fresh hunt for yield would be likely to increase appreciatory pressure on their exchange rates.
| Diverging Inflationary Paths Create Different Policy Prescriptions |
|Emerging Europe - Consumer Price Inflation, % chg y-o-y|
However, economies across emerging Europe are facing their own challenges too, and stronger exchange rates will in many cases be seen as a burden rather than a boon, particularly in the export-driven economies of Central and South-Eastern Europe where a stronger currency would reduce export competitiveness. Inflation in Central Europe also remains exceptionally weak: a stronger exchange rate would materially increase the risk of deflation across the region, which will be particularly unwelcome, dampening investment while these economies are entering the early/middle stages of their growth cycle. Consequently, we expect that most central banks across emerging Europe would adopt activist stances to mitigate any negative impact from QE. However, regional central bank's scope to act will vary significantly, and in some cases is limited.
| QE Could See Non-Resident Ownership Rise Again |
|Poland (lhs) & Hungary (rhs) - Foreign Ownership Of Domestic Debt, % Total|
Central And South-Eastern Europe: Likely To Fight Back
Poland - Cut Reserve Ratios, Delay Hikes: Inflation remains exceptionally low in Poland and is likely to remain below the lower bound of the National Bank of Poland (NBP)'s target inflation range across 2014. While Poland is less dependent on exports for growth than other CE-4 economies, it's tolerance for a stronger zloty is limited by the prevailing deflationary threat.
The monetary policy committee (MPC) has expressed concern about the potential impact of highly expansionary monetary policy by the ECB, and central bank governor Marek Belka has announced they are preparing unspecified instruments to intervene on different asset classes. While the central bank has some room to cut the policy rate - currently standing at 2.50% - further, we think the authorities would be disinclined to adopt a more dovish stance unless the currency strengthened substantially beyond PLN4.0/EUR. That said, we think Poland is less likely to cut rates as the MPC remains fundamentally hawkish and economic conditions highly supportive of growth. We think the MPC would be more inclined to combine lower reserve ratios with delayed rate hikes (H215 or later) rather than cutting the policy rate further.
Hungary - Further Cuts Possible... But Risky: The Hungarian central bank has much less tolerance for currency strength than other CEE economies, with government influence on the MPC strong and biased towards the promotion of exporters. With Hungary just in deflationary territory (-0.1% in April) the MPC has room for manoeuvre with regard to rates, which we believe is much more likely than direct FX intervention. However, this deflationary trend is not broad based, instead primarily resulting from government mandated energy price cuts.
With domestic demand looking to be on the rise and the base effects from price cuts wearing off, inflation will come back into play by year-end, potentially limiting the ability for additional rate cuts. In addition, with MPC statements becoming more hawkish month-on-month, we believe that rate hikes may instead be delayed until Q115. Any further easing would pose risks to large short-term external liabilities (26% of GDP), which could head for the door in the event of unexpected easing.
Czech Republic - Exchange Rate Floor To Remain Primary Defence: The Czech National Bank is already hamstrung on the policy rate front, with rates effectively already at the zero bound. The Czech National Bank is instead likely to rely on the floor it has set against the koruna against the euro at CZK27.00/EUR. With the economic rebound picking up steam in H114, and with inflationary pressures likely to pick up in H214, instead of easing further the CNB's likely response to stalling consumer price growth is to stop intervening in FX markets at a later point than it previously planned and to delay the first interest rate hike. Given that the CNB has pledged to maintain FX intervention at least until early 2015, we expect it to stop intervening in Q215, although this would almost certainly be delayed until H215 under our QE scenario.
Romania - Modest FX Intervention, Delayed Hikes: We believe the National Bank of Romania (NBR) will be relatively tolerant of leu appreciation in the wake of ECB quantitative easing. A strong RON would benefit the banking sector, helping the high proportion of lenders who have taken out loans in FX to repay their debts amid deteriorating asset quality (NPLs are already over 20%). Furthermore, comparatively low labour costs make it likely that a strong leu would not significantly damage exports, which have remained strong despite recent leu resilience.
In the event of strong leu appreciation, we would expect the NBR to begin FX interventions to weaken the currency, rather than lower the policy rate. Although inflation came in at just 1.0% y-o-y in April, base effects and recovering domestic demand will ensure that inflation ends the year above the NBR's 2.5% target. With consumer spending also showing significant signs of recovery, at most we could see the NBR delay its first rate hike to the second half of 2015 (from our current projection of a rate hike in Q115).
| Some Room To Cut Rates As A Last Resort |
|Regional Policy Rates, %|
Turkey & Russia: ECB QE Could Be A Boon
Turkey - Cut Rates, At The Expense Of Imbalances: In our view, the Central Bank of Turkey (CBRT) is the regional central bank most likely to respond to ECB QE with domestic monetary easing. In fact, we see a high probability that the CBRT could begin cutting rates in the coming months even in the absence of ECB action, although this is not our core scenario. After hiking rates aggressively in January to defend the lira from a disorderly sell-off, the CBRT has hinted that lowered risk premiums (evidenced by lira appreciation and falling government bond yields) since March now provide scope for easing. Insofar as an ECB QE programme could lead to stronger capital inflows, further gains in Turkish financial markets and a gradual easing of inflationary pressure from exchange rate pass-through effects, this would bolster the CBRT's case for interest rate cuts.
That being said, we also view Turkey as the most at risk from monetary policy easing. While an ECB QE programme would likely provide the CBRT with scope to cut rates without a massive loss of credibility, we nonetheless believe that this could once again expose the structural weaknesses of the Turkish economy. Strong capital inflows and falling interest rates in from H212 to H113 led to a significant widening of Turkey's current account deficit, which is the primary driver of Turkey's volatile growth trajectory and susceptibility to rapid financial market sell-offs.
Russia - Enjoy The Ride: The Central Bank of Russia has plenty of tolerance for a stronger rouble, which would help to bring down persistently above-target inflation and provide a boost to household purchasing power, which has been under pressure of late, as well as helping to replace inbound capital flows lost after the outbreak of the Ukraine crisis and Russia's subsequent annexation of Crimea. In this regard, we think Russia would be one of the few Emerging European economies to adopt a flexible, rather than activist monetary policy, allowing the rouble to appreciate and doing little to redirect or sterilise external capital flows into the country.