Can Central and Eastern Europe Resist the Debt Crisis?

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1 June 21 Can Central and Eastern Europe Resist the Debt Crisis? After having hurt Greece and other Euro Periphery countries, the wave of Sovereign Debt fears has reached the Central and Eastern European region as Hungary was put under pressure to reassure markets who remember how sensitive Central end Eastern European countries have been to the 28 Credit crisis while most of these countries tentatively emerge from this deep recession.

2 Can Central and Eastern Europe Resist the Debt Crisis? Citi analysts observe that Western Europe s turmoil has affected financial markets in Central and Eastern Europe (CEE) worse than anywhere else. CDS Spreads of CEE countries have indeed been much more sensitive to events in Western Europe than CDS Spreads of other Emerging Markets since the beginning of the year while the Hungarian Forint and the Polish Zloty have been the worst-performing emerging markets currencies during the six week period starting on 1 April, regardless of whether the USD or EUR are used as a base currency. Citi analysts estimate that the Neighbourhood risk is increasing and they envisage 3 possible contagion mechanisms: Financial, Economic or Thematic The Financial contagion mechanism works via the wide openness of CEE countries financial markets to Western European banks and more particularly to Greek Banks. Citi analysts observe that with the exception of Russia, Turkey and Ukraine, European banks retain high levels of exposure to CEE as a percentage of country GDP. This creates vulnerability for economies that remain dependent on the willingness of foreign creditors to remain exposed to Europe s periphery. Citi analysts observe that since the Lehman crisis, foreign banks were net takers of repayments in 8 of the 1 largest CEE countries. They think that further reduction in risk appetite is likely if European banks are faced with a growing capital shortage. on final demand in third countries. Since the Euro s recent depreciation, on balance, might support net exports, then CEE s vulnerability may be smaller than overall exports to Western Europe numbers suggest. Finally, the thematic mechanism relates to the concerns about high debt/gdp ratios in Western Europe that could in turn trigger doubts about CEE countries with similar problems. Citi analysts estimate that, with the exception of Hungary, the Thematic contagion should be less of a risk to CEE. Citi analysts observe indeed that even in countries where the debt/gdp ratio rose very sharply between 27 and 29 Latvia, Ukraine, Romania the starting point was a very low public debt burden and remain far from the average level of the Euro Area. Only Hungary, with a debt/gdp ratio of 8% compares to the average level of the Euro Area. On balance, Citi analysts estimate that a deepening of Euro Area woes would have negative consequences for CEE, but that none of the contagion mechanisms highlighted sound loud alarm bells for CEE at the moment given the absence of public debt concerns, the lower reliance on credit and the potential benefit from a weaker Euro. However, Citi analysts estimate that the effect of financial contagion could be minimized by the fact that CEE isn t credit-dependent these days. They observe that CEE countries proceeded to substantial current-account adjustments in 29 which reduces credit demand for the economy as a whole. In addition, Citi analysts think the pre-lehman growth model based rapid domestic spending growth built on plentiful credit-availability has broken broke down. In the aftermath of that breakdown, credit demand and domestic consumption have sharply decreased and Citi analysts expect that external demand will be the critical driver of GDP in many countries. The Economic mechanism is the mechanism by which doubts about the Euro Area s growth prospects can have a negative impact on both exports from CEE and capital flows to CEE. Given the evolution towards a more exportdriven economic growth, a weaker Euro Area growth could constitute a new kind of external shock to the as only two countries, Turkey and Ukraine, sell less than 5% of their exports to the Euro Area. However, assessing CEE s vulnerability to economic contagion is complex. There is indeed a share of CEE s exports to Western Europe Germany in particular which don t depend on final demand in the EU, but are part of a production process which depends Source: Citi Investment Research & Analysis, Emerging Markets Macro and Strategy Outlook May 21 2

3 United States Euro-Area S&P 5 DJ EURO STOXX 5,2,1 -,1 -,2 -,3 -,4,2 12,12%,1 7,15% -1,56% -5,39% -7,57% -,1 -,2-13,25% -,3-31,44% -,4 -,5-42,68% 1 M YTD 1 Y 3 Y 1 M YTD 1 Y 3 Y Mounting threats from Europe Evidence has mounted that strong profits have prompted new spending and hiring that will support healthy labour income as government supports fade, Citi analysts say. Citi analysts estimate that Consumer and business spending will compensated lagging construction and state and local government woes. Housing markets have shown signs of steadying in recent months and the small business sector appears to be catching up to the broader upturn. However, they think that renewed risk aversion and eroding liquidity stemming from events in Europe may pose threats to financial stability necessary for continued U.S. economic recovery and suggests that monetary policy may need to remain focused on maximum accommodation longer than they anticipated. Citi analysts observe that Inflation is slowing to 1%, reflecting the sharp relative decline in housing costs and massive economic slack. However, reviving income and stable inflation expectations should help steady pricing beyond the near term. Citi analysts observe that sentiments have turned to panic and that US equities are largely undervalued. They observe that 1% of the current market valuation implies that there is almost no long-term projected earnings per share growth being assumed by the investment community currently. More divergences expected Citi analysts have left their GDP forecast for 21 unchanged at 1.1.% YoY, but they expect the growth divergence between the fiscally most strained countries, which have announced additional austerity packages for this year, and the less fiscally strained countries to widen. In order to contain the contagion from the Greece sovereign, the European Council agreed on a European Stabilisation Mechanism worth 75 billions and the European Central Bank (ECB) has been entitled to purchase sovereign debt on the secondary market. Citi analysts estimate that this programme averts the risk of an imminent default of a Euro Area member-state but is not likely to prevent a restructuring of the Greek debt. Citi analysts believe the European Central Bank will keep rates unchanged until end of 211 given the outlook for weak growth and inflation in the coming years, and to avoid liquidity pressures. Strengthening recovery and positive operational leverage may drive a robust rebound in corporate earnings. Citi analysts are expecting 21 & 211 European earnings growth of 2%+. However, Citi analysts feel that there may be better structural growth opportunities in emerging markets equities and better cyclical growth opportunities in the US than those offered by exposure to the domestic economy. Thus they continue to prefer companies with international exposure. 3

4 Asia Emerging Markets MSCI Asia Pacific MSCI Emerging Markets 2%,3 1% 9,29%,2 2,58% % -1% -2% -3% -4%,1 -,6% -6,36% -,91% -,1-7,22% -26,23% -13,37% -,2 1 M YTD 1 Y 3 Y 1 M YTD 1 Y 3 Y Japan Bank of Japan likely to keep policy rates on hold through 1H11 The economy may continue to grow at a pace above the potential growth rate in quarters to come, under a combination of a continued uptrend in exports, a pickup in business and housing investment and a modest improvement in labour conditions. In Citi s view, the cyclical mechanism in which export growth drives activity could remain intact in 21, thanks to the resilience in other Asian economies. Meanwhile, companies appear to remain cautious about increasing personnel costs and this is likely to limit a spillover to household income but may push up corporate profits strongly this year. Citi analysts expect the Bank of Japan (BOJ) to maintain the current policy rates until late-211. Asia Pacific Reduced inflation pressures Asia s recovery is broadening, with sustained final demand recovery in the US and domestic demand revival in the region, according to Citi analysts. Meanwhile, inflation has recently almost unanimously surprised on the downside. Citi analysts think subdued demand in advanced economies has inadvertently slowed the inflationary upturn in Asia, allowing Asian policymakers to be less aggressive in unwinding its very accommodative policies. In particular, Citi analysts favour the North Asian markets of Hong Kong, Korea and Taiwan. Sector-wise, they believe that banks have an inevitable role in all economic recoveries. At the same time, valuations look attractive. Gradual exit of recession in CEEMEA While other Emerging Markets may continue to normalise monetary conditions through policy rate hikes in the coming months, hikes may be barely visible in CEEMEA1, where in many cases rates are still high in the wake of the crisisrelated need for monetary tightening in 29. The biggest hike this year could come through in Turkey, where rates remain unsustainably low, in Citi s view. Latin America s recovery appears on track and Citi analysts believe that rising inflation, higher inflation expectations and smaller output gaps should prompt most of the tightening cycle in the region. Most Latin American currencies are likely to continue benefiting from the global recovery, commodity prices and capital inflows in the short term. In CEEMEA, Citi still forecasts currency appreciation (particularly South African Rand (ZAR) and Polish Zloty (PLN)), despite the ongoing concerns in the Eurozone periphery. Citi analysts believe 21 is likely to be a year of more modest gains in MSCI Latin America as markets wait for corporate earnings to catch up to the high valuations at end-29. They are overweight Brazil and Mexico. Despite a number of global concerns, Citi analysts remain positive on CEEMEA over the medium term given that economic data has been beating expectations, earnings forecasts have been rising and valuations remain undemanding. They are more cautious on the near term and acknowledge a potential higher vulnerability to the Sovereign credit crisis in the Euro Area. They are overweight Russia. 1. CEEMEA is the collective term for Central and Eastern Europe, Middle East and Africa. 4

5 Russia and Ruble Other Currencies,4,2 -,2 -,4-2% -4% MICEX 35% -21% 1 M YTD 1 Y 3 Y 15% 13% 11% 9% 7% 5% 3% 1% -1% -3% -5% -7% -9% -11% -13% -15% USD/RUR -2,2% -3,% -,6% USD/EUR -14,5% 13,6% -1,5% EUR/RUR USD/GBP 2,8% -7,5% 1M YTD End of the rate-cut cycle Key indicators on economic activity show stronger recovery than suggested by the preliminary Rosstat estimate of 2.9% YoY growth in 1Q1. Although these data does pose a risk to 6% growth forecast for 21, made by Citi analysts, they do not revise the forecast at present. Consumer spending is gradually getting up to speed as confidence improves and real incomes increase. Based on our analysis, we expect retail sales growth to reach 7%YoY in the second quarter of 21. According to Citi analysts, there are signs that pressure might re-emerge in mid-21 for the government to increase spending, as the fiscal deficit might fall to 3%-3.5% in 21 on the back of higher than budgeted oil prices, domestic consumption and imports. Russia s debt-to-gdp, at below 1%, compares favourably to other G-2 countries, but large private sector external debt at 3% of GDP poses some risks. At the end of June Central Bank of Russia decided to leave the level of refinancing and other policy interest rates unchanged in view of the ongoing improvement in economic activity and positive trends in the financial sector. The last time the CBR cut the refinancing rate was at end-may to 7.75% bringing it down by 525bp since April 29. Citi analysts think that further rate cuts are unlikely as inflationary risks are expected to grow at the end of 21 Citi analysts estimate that the cyclical underperformance of the Euro Area against the US combined increased risk aversion due to debt woes in the Euro Area could drive the Euro to test the level of 1.15$/ in the coming months. On the longer term, Citi analysts estimate the equilibrium rate at 1.33$/ which makes the Euro strongly undervalued at the current levels. The Euro could find support later in the year on increased risk appetite and focus on US own deficit and debt challenges. The plan of the new UK government is to cut fiscal spending and raise taxes to make a significant early reduction in the budget deficit in order to avoid the risk that the UK is downgraded and markets force adjustments on the UK. A lower debt path, better credit rating and an improved current account balance should all boost sterling s long term value. In the short to medium term, however, in which we investors have to operate, this mix of easy money and tight fiscal tends to weaken currencies The risk of weaker Euro Area growth and its potential negative impact in CEEMEA currencies, especially in Central Europe markets, has increased. However, the majority of Citi analysts short term forecasts in CEEMEA continue to be bullish versus forwards. This is particularly the case for the Ruble and the Zloty. They also expect monetary policy tightening in the first place will take the form of higher reserve requirements and/or ruble appreciation, with rate hikes postponed until late 211. Citi analysts expect ruble to strengthen by the end of the year. Current forecast of foreign exchange rates by the end of /$, 37.5/ Citi analysts think that Russian stocks look cheap now. A review of fundamentals suggest that Russia is at the bottom of the emerging market valuation spectrum. Among different sectors Citi analysts prefer energy, banks and utilities. 5

6 Bond markets High-grade corporate debt expected to outperform US Treasuries Citi analysts expect interest rates to be range-bound with tighter monetary measures beginning in the second half of the year, boosting term premiums. US Corporates While further narrowing is likely to be modest given that spreads are approaching long-term equilibrium levels, Citi analysts continue to expect corporate debt to outperform other high-grade sectors. Meanwhile, High yield spreads are anticipated to continue grinding tighter over time as positive technical factors and improving fundamentals support performance. Euro Bonds Fiscal burdens in peripheral Euro zone nations present key risks to higher rates in Germany. In the UK, Citi analysts favour short duration exposure as outsized fiscal burdens and inflation pressures dampen performance prospects. Emerging Market Debt Citi analysts are constructive on Asia and Latin America credits as improved liquidity and risk appetite persist. Important Disclosure: This document is not intended as an offer or solicitation for the purchase or sale of any security. All information can be changed without notification. It is provided only for your information.despite the fact that this information was received from different public and internal reliable sources, ZAO Citibank, Citibank N.A., Citigroup Inc. or their affiliates do not guarantee its accuracy and authenticity and are not responsible for direct or indirect losses that can appear while using this information. Investment products are not insured by the government, they are not deposits, not guaranteed by the bank. Investment products can lose their value including principal payment. Investment assets in foreign currencies are subject to currency risks that can lead to the total or partial investment principal losses. Before acting on the information, you should consider its appropriateness, having regard to your objectives, financial situation and needs. Any decision to purchase securities mentioned herein should be made based on a review of your particular circumstances, tax implications, legal and account aspects. This information can not be copied or distributed for other people excluding professional client advisers. Past periods results do not guarantee future results, indices can go up and down. This information is meant only for ZAO Citibank clients. As per Federal Law No. 39-FZ from (with amendments of ) securities of foreign issuers which are not allowed for public placement and (or) public circulation on the territory of the Russian Federation are not allowed for offering in any form and by any means, including advertising, to an undefined circle of individuals as well as to non-qualified investors. These products are reserved for offering (subscription) solely to Qualified Investors. Sources: Citi Monthly Outlook June 21; Citi Russia Macro View: Recent Developments and Policy Challenges for 211; Сiti Russia Macro Flash: End of the rate-cut cycle; Citi Russia Strategy Notebook; MSCI; Reuters. 6