Growth might show positive surprise

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1 Baltic Outlook Growth might show positive surprise Violeta Klyvienė Senior Baltic Analyst , April 2011 vkly@danskebank.dk Important disclosures and certifications are contained from page 24 of this report.

2 Recovery is gaining momentum The Baltic economies are recovering from the recession relatively rapidly. The faster-than-expected than expected rebound in 2010 was mainly due to strong export growth. Final consumption expenditures and gross fixed capital formation decreased annually, but both indicators have improved since H2 10. Exports remain the main growth driver. The Baltic countries export orientation to fast-growing economies (Sweden, Finland, Russia, Germany, Poland) is a clear advantage. Source: Reuters EcoWin, Danske Markets, [both charts] 2

3 The recovery of domestic demand in the Baltics was weak last year, as households and businesses were still feeling the effects of deleveraging and tough fiscal consolidation processes. We expect domestic demand to start to make more of a sustainable recovery in Key assumptions for this recovery are a healthier banking sector, faster income growth and low base effect. However, there is a risk that rapidly rising consumer prices could slow down the recovery in consumption. Domestic demand Source: Reuters EcoWin, Danske Markets [both charts] 3

4 Labour market outlook Labour market is recovering slowly. Unemployment is expected to be long term or structural, as job losses are mostly concentrated in the construction industry and the restructuring of the Baltic economies is still under way. Source: Reuters EcoWin, DanskeMarkets 4

5 Prices Inflation picked up in 2010, mainly caused by yprice increases in external markets a trend we expect to continue this year. Currently there is no strong fundamental reason for significant inflationary ypressure and expected upside in CPI inflation in 2011 will be mainly driven by external factors and higher indirect taxes (Latvia). This time all the risks to our CPI inflation forecast are on the upside. Source: Reuters EcoWin, Danske Markets 5

6 Country-specific comments

7 Lithuania: Recovery is picking up steam Lithuanian i GDP increased by 4.8% y/y in Q4 10, up significantly from 1.2% y/y in Q3 10. In Q4 the Lithuanian economy was supported by the more notable recovery of domestic demand, especially investment. It looks as if fiscal policy was relatively accommodative last year and supported GDP growth as well. Lithuanias economy is recovering faster than we had predicted and we cannot rule out a significant acceleration this year as well. Key monthly economic indicators in January, February were strong. A continuation of this trend would be an important precondition for raising our basic forecast for this year from 3.6% to %. Source: Reuters EcoWin, Danske Markets [both charts] 7

8 External demand The recovery will continue to be highly dependent on foreign demand. Prospects for the export-oriented industries remain good for this year as well, with exports to Lithuanias major export partners expected to grow very rapidly. Exports to Russia, Germany and Poland are very important, accounting for more than 30% of total exports in Electrical equipment, pulp and paper, textile, chemical and plastics industries continue to show a rapid recovery. Lithuanias export market diversification reduces the risk of high dependence on a single source of growth. Source: Reuters EcoWin [both charts] 8

9 Labour market Unemployment is starting to ease and consumer confidence is edging up. However, a significant part of unemployment is structural or long term. In order to reduce structural unemployment implementation ti of comprehensive measures and reforms is required. A large part of the unemployment problem will be solved by emigration, which has remained at a high level at the beginning of this year. In the short term, this process is not particularly harmful. However, in the long term, it will mean a higher debt and ndtax burden and ndless sustainable pension and welfare systems. Although unemployment remains high, skill mismatches in certain sectors could lead to faster wage growth. We now expect average wages to grow by 2.6% y/y in 2011 (versus our previous expectation of 1.3% y/y) and by 3.9% in 2012 (2.6% y/y previously). Source: Reuters EcoWin [both charts] 9

10 Fiscal policy aims to reduce the fiscal deficit to 3% by This remains a major challenge for the economy. In 2010 the deficit was around 71%of 7.1% GDP and in 2011 it is expected to fall to around 5% of GDP. Lithuania might delay its eurozone entry beyond the 2014 target. However, inflation is the main threat. Inflation will pick up further mainly due to price increases in external markets. As a result, the possibility of reducing inflation is very limited. Fiscal policy Source: Reuters EcoWin [both charts] 10

11 Real estate market The real estate market is in a stabilisation process. The credit policy of banks is becoming less conservative and competition in this sector is gradually increasing. Opportunities to develop new projects are relatively favourable currently as construction costs decline and confidence improves. On the other hand, a quick rapid recovery in demand is hardly expected given a still difficult household situation. We expect to see a gradual recovery based on rising incomes and an improving labour market. Historical data indicate that real estate prices lag the overall economic cycle. Thus, if the recovery became firmly established in H2 10, the positive trend in the property market will not be visible until H2 11. The real estate market still has very good potential for development as many people live in old housing (energy inefficient) and the renovation process has not proven as smooth as expected. Constantly rising costs of inefficient facilities make people look for alternatives. 11

12 Preliminary forecasts Source: Reuters EcoWin, Danske Markets 12

13 Estonia The Estonian recovery accelerated significantly in Q4 10. GDP increased by 6.7% y/y, up from 5.0% y/y in Q3 10, due to vigorous export results. Estonias s export growth in 2010 posted a record high; exports of goods and services increased 22% y/y, while exports of goods % y/y % y/y increased 33% y/y. 0 0 The recovery is highly dependent on foreign demand, especially the northern region. The main risk to our forecast is a slowdown in growth in Sweden and Finland, but significant downside risk in these markets is limited. Last months export growth remained exceptionally high and main export markets prospects remain positive. Therefore we are likely to revise our estimates for this year from 3.9% to % GDP Export Source: Reuters EcoWin, Danske Markets

14 Domestic demand is recovering more slowly than in Lithuania and Latvia mainly due to a more restrictive fiscal policy. We expect the recovery in investments to accelerate in 2011 helped by a gradually resurging banking sector. During the Estonian government plans to implement the modernisation of the energy sector and this will have a positive impact on investment dynamics. Greater confidence in the Estonian economy due to its eurozone membership could also encourage capital inflows. We have seen some increase in foreign investment flows. Domestic demand Source: Reuters EcoWin, Danske Markets [both charts] 14

15 The labour market improved in In the last quarter, after nearly a twoyear hiatus, employment increased by 2.2% y/y. The unemployment rate decreased gradually throughout 2010 and reached its lowest level el in Q4 10 (13.6%) in the Baltic region. At the end of 2010, long-term unemployment started to fall as well. A faster decline in unemployment will depend on the opportunities for retraining and a recovery in the construction sector. Labour market Units Vacancies Unemployment Source: Reuters EcoWin %

16 Major risk inflation Estonian inflation accelerated again in February: CPI increased to 5.7% y/y from 5.3% y/y in January. The upward trend was mainly the result of the continuing rise in food and fuel prices. Commodity prices continue to increase in the global market and we saw a relatively strong pass-through effect on the domestic price level. We have revised our inflation forecast for up somewhat. However, we still see a modest risk that rising inflationary pressures may slow down the domestic demand recovery perspective. Source: Reuters EcoWin, Danske Markets 16

17 According to preliminary data, Estonian public finances showed a small surplus of 0.1% of GDP in The Estonian government continued to implement a significant fiscal consolidation policy last year. The Estonian public deficit remains the smallest in the euro area, which gives some room for fiscal relief in Fiscal policy Source: Reuters EcoWin 17

18 The real estate market is recovering along with the improving macroeconomic growth outlook. However, it looks like the real estate market recovery is behind the economic cycle. A more significant rebound in housing prices, which was observed at the end of 2010, can be explained by the euro issue. Real estate market Meanwhile, there is a risk that at the beginning of this year this positive surprise might have come to a halt. Source: Estonian statistics In general, we expect to see a continuation of the gradual recovery of the real estate market in line with the improving economic situation and increasing confidence in the economy. 18

19 Preliminary forecasts Source: Reuters EcoWin 19

20 Despite some uncertainty caused by fiscal consolidation, the recovery of the Latvian economy remains on track. Growth increased 3.7% y/y in Q4 10, compared with 2.9% y/y growth recorded in Q3. The faster-than-expected rebound was driven not only by high export growth, but also by improvement in domestic demand. Looking forward, we expect economic growth to accelerate further. However, it is too early to say that challenges to the economic climate are a thing of the past. So far we see no reason to significantly revise our base forecast. We forecast the Latvian economy will grow 3.2% y/y in Latvia Source: Reuters EcoWin, Danske Markets 20

21 Inflation Despite weak domestic demand, consumer prices accelerated in H2 10, largely due to external factors. The recent hike in VAT rates will be the main contributor to higher inflation this year. Accelerating inflation is a strong risk factor that may adversely affect economic recovery. Looking ahead, inflation is likely to accelerate further, driven by both domestic (higher electricity tariff) and external factors. Thus, we expect to revise up our inflation forecast in 2011 significantly to 4% on average (from the previous 2.4%). Inflationary pressures are expected to decline in Source: Reuters EcoWin, Danske Markets 21

22 Fiscal policy Latvia continues with its impressive fiscal consolidation in Budgetary adjustments would account for more that EUR415m in Latvia's chances of adopting the euro in 2014 seem relatively solid. However, as for Lithuania - the biggest threat would be the failure to comply with inflation criterion. Source: Reuters EcoWin, Danske Markets 22

23 Preliminary forecasts Source: Reuters EcoWin, Danske Markets 23

24 Disclosure This research report has been prepared by Danske Research, a division of Danske Bank A/S ("Danske Bank") ). The author of the research report is Violeta Klyviene, Senior Baltic Analyst. Analyst certification Each research analyst responsible for the content of this research report certifies that the views expressed in the research report accurately reflect the research analysts personal view about the financial instruments and issuers covered by the research report. Each responsible research analyst further certifies that no part of the compensation of the research analyst was, is or will be, directly or indirectly, related to the specific recommendations expressed in the research report. Regulation Danske Bank is authorized and subject to regulation by the Danish Financial Supervisory Authority and is subject to the rules and regulation of the relevant regulators in all other jurisdictions where it conducts business. Danske Bank is subject to limited regulation by the Financial Services Authority (UK). Details on the extent of the regulation by the Financial Services Authority are available from Danske Bank upon request. The research reports of Danske Bank are prepared in accordance with the Danish Society of Financial Analysts rules of ethics and the recommendations of the Danish Securities Dealers Association. Conflicts of interest Danske Bank has established procedures to prevent conflicts of interest and to ensure the provision of high quality research based on research objectivity and independence. These procedures are documented in the research policies of Danske Bank. Employees within the Danske Bank Research Departments have been instructed that any request that might impair the objectivity and independence of research shall be referred to the Research Management and the Compliance Department. Danske Bank Research Departments are organised independently from and do not report to other business areas within Danske Bank. Research analysts are remunerated in part based on the over-all profitability of Danske Bank, which includes investment banking revenues, but do not receive bonuses or other remuneration linked to specific corporate finance or debt capital transactions. Financial models and/or methodology used in this research report Calculations and presentations in this research report are based on standard econometric tools and methodology as well as publicly available statistics for each individual security, issuer and/or country. Documentation can be obtained from the authors upon request. Risk warning Major risks connected with recommendations or opinions in this research report, including as sensitivity analysis of relevant assumptions, are stated throughout the text. First date of publication Please see the front page of this research report for the first date of publication. Price-related data is calculated using the closing price from the day before publication. 24

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