EM Vulnerability Snapshot: Hungary improves the most since crisis

A quick vulnerability snapshot - Hungary shows the greatest improvement

What variables do investors care about? Morgan Stanley’s vulnerability Scoring Indicator (VSI) takes several variables (current account, external debt, short-term external debt/FX reserves, LTD ratio, FX loans as a percentage total, budget deficit, government debt) and creates an equally weighted average of each indicator’s deviation from the regional average, expressed in standard deviations.

“Compared to pre-crisis levels, Ukraine, Russia, Turkey and South Africa have worsened. However, most of EM Europe is actually less vulnerable and Hungary shows by far the most significant improvement, thanks to steadily improving external metrics. This underpins our view that credit upgrades are overdue in Hungary," Morgan Stanley said in its chart pack.

Key takeaways

In a chartbook released on Tuesday, MS takes stock of

• where EM Europe is in terms of real and nominal convergence;
• what its economies produce, and
• how competitive they are;
• what demographics pressures they face, and
• how their growth models have fundamentally changed over the last few years;
• how EM Europe is diverse, and Central Europe fundamentally differs from South-East Europe; and
• how sensitive EM Europe is to oil, China and specific sectors like autos.

Finally, MS looks at the broader issue of EM Europe’s institutional convergence and its place within the EU.

Below are Morgan Stanley’s key takeaways:

• Income convergence has progressed, with nominal GDP per capita at 40% of euro area levels, up from 27% ten years ago. However, winners and losers have emerged. Poland, Slovakia, Romania and the Baltics have continued to converge at a good speed, whereas others (Hungary, Croatia and Slovenia) have disappointed.
• Price convergence has also taken place, mostly on the tradable side, whereas the gap in services prices is still wide (around 55%), which still leaves plenty of nominal catch-up. Inflation is low, particularly so in the Czech Republic and Poland.
• On the supply side, EM Europe economies have a strong industrial base. Being part of the German supply chain is a key reason for this (especially for Central Europe).
• EM Europe remains very open and is ever more integrated in global trade flows. The region remains cost-competitive, especially looking at wages (somewhat less if we look at unit labour costs).
• There is scope for improvement in terms of energy efficiency, and for a more diverse energy mix. Some countries (Poland, Hungary) are trying to reduce their dependence on Russian energy.
• EM Europe experienced a classic boom-bust cycle in lending and real estate, which it is now recovering from. Potential growth may well be lower now (2.5-3%Y), but external balances look strong and vulnerabilities have by and large fallen compared to a few years ago (Hungary stands out). Excessive leverage is not an issue, unlike in other parts of EM.
• Poor demographics are an issue, yet pension systems do not look especially weak in a broader context, due to past reforms. Participation rates are too low and policy-makers will have to find ways to increase them.
• Revisiting sensitivities: MS looked at EM Europe’s sensitivity to oil prices, Chinese growth and the auto sector.
• MS also looked at the state of construction and real estate activity across EM Europe, which shows a very diverse picture, with Poland and the Czech Republic having held up better than their neighbours. Hungary and Romania are also improving, however.
• EU structural funds have been a key growth driver since accession: The ability to absorb these funds varies widely across the region, with Poland doing particularly well. EU funds are likely one of the reasons why EM Europe countries tend to be more pro-EU than their Western neighbours, though EU support has decreased since accession. Support for euro accession is down everywhere since 2004, and is particularly low in Poland and the Czech Republic.

How has converged? Who hasn’t?

EM Europe countries have GDP per capita which are around 40% of euro area (EA) levels, up significantly since the first wave of enlargement (2004), when incomes were 27% of EA levels. However, note that the bulk of this convergence took place between 2004 and 2008, before the Great Financial Crisis (GFC).

In recent years, countries such as Slovakia, Poland, Romania and the Baltics have continued to converge at a good speed, whereas Hungary, Croatia and Slovenia have disappointed.

The drivers of convergence (productivity catch-up, capex) are still the same, but the pace of convergence is likely to slow down from the fast speed seen in the post-EU accession years.

CEE versus SEE: Intra-EM Europe Divergences

Not all EM Europe looks the same. CEE countries (the Visegrad 4) have grown faster and are generally in better shape than countries in South-East Europe and the Balkans: One of the reasons for this is that strong FDI flows prior to the crisis expanded the production capacity of the private sector in CEE, but did so to a lesser extent in SEE.

The surge in private capital flows to CEE increased the overall share of the private sector and lowered further the size of the state. Conversely, in SEE the government remained one of the main employers, and government debt stocks were ramped up.

Real GDP growth has outpaced price convergence

Over the last ten years, gains in real GDP per capital have exceeded increases in price levels in the vast majority of countries, by a large margin. Real convergence in living standards has therefore proceeded faster than price convergence.

In terms of their consumption patterns, EM European countries tend to spend more on necessities, such as food and energy. This is very common for developing economies. Over time, as incomes catch up to Western European levels, Morgan Stanley would expect the proportion of income spent on leisure, travel and other services to approach euro area levels (over 40%). Note that these trends have already started to show in the data, particularly in Romania and Bulgaria.

Industry dominates the supply side

EM Europe economies have a strong industrial base [...] industry as a percentage of total value added is still around 5-10pp higher than in the euro area. Over time, these converging economies might see more of their activity move into services as they get richer, but this will be a slow-moving process and they will likely remain manufacturing-intensive.

Within industry, the countries in CEE clearly have a comparative advantage in sectors such as automotive. Poland, the Czech Republic, Hungary and Slovakia (i.e., the ‘Visegrad 4’) combined are the second-largest car producer in the EU, with around 3 million vehicles produced (Germany is on top with around 5.5 million). However, their combined GDP is only 25% of German GDP. Note also that there is a trend in the whole region towards upscaling from low to high-tech production.

EM Europe trades a lot, relies on FDI for funding

EM European economies are small and open, with the exception of Poland, Croatia and Romania. The combined sum of imports and exports stands at 175% of GDP in Hungary, 163% in the Czech Republic and well over 100% in the Baltics.

FDI is a key engine of growth: FDI from Western Europe (mostly Germany) has favoured technology transfer, innovation and efficiency gains. With some caveats, FDI is a comparatively stable source of investment. Conversely, inflows which are mostly financial in nature (bank inflows, for instance) tend to be more flaky and give rise to boom-bust cycles.

How much does Germany matter?

Trade with Germany is very important for EM Europe: In the Czech Republic and Hungary, exports to Germany account for 27% and 23% of GDP, respectively, whereas the ratios in Slovakia (18%), Poland (10%) and Romania (7%) are smaller. Similar relationships exist on the import side.

But the official trade data mask an interesting underlying change: EM Europe is becoming more global: Often goods leave the region (mostly CEE) in the form of machinery and equipment, arrive in Germany and then are re-exported from there onto Asia or the US. For this reason, sometimes Germany is simply acting as a proxy for other countries’ demand. The World Input-Output Database allows for a more granular description of trade flows. IMF studies show that the dependence on German demand is 30-40% less than other data (like the IMF’s DOTS) imply. This is because some exports to Germany find their way to other destinations. The upshot is that, in such an integrated supply chain, Germany is EM Europe’s gateway to the world, and EM Europe is increasingly trading with other regions (likely Asia and other EM).

Highly dependent on Russian oil and gas

Gas is almost as important as oil in Hungary, Bulgaria, Lithuania and Slovakia. Romania runs the smallest energy gap in all of EM Europe, being comparatively oil and gas-rich.

In terms of supply, it is not surprising that the region largely relies on Russia to fulfil its energy needs. This explains the effort to diversify its energy sources: for instance, Poland has dramatically reduced its reliance on direct supply of Russian gas in the last couple of years (via construction of a LNG terminal at Swinoujscie, among others), and Hungary is investing in nuclear energy, with the construction of two new reactors and the refurbishment of two additional reactors of the Paks II nuclear plant.

Still reeling from the credit bust...

Since 2008, European banks have sharply cut down the supply of credit, particularly where those bubbles had been most severe. Credit growth is only beginning to turn up modestly, but remains in single-digit levels across the region

Increase in overall leverage has been modest since the crisis

Following the GFC, CEE has been on a debt diet compared to most of the rest of the world. Debt ratios in Poland, Hungary and the Czech Republic have increased on average by 28% of GDP compared to a world average of 39%. A large part of this increase in Hungary and the Czech Republic was due to the general government.

Looking at trends (right-hand side chart), the private sector in Hungary is continuing to deleverage, but government debt has been keeping the overall non-financial sector debt stable. As an aside, note also that Hungary screens as a ‘high-debt’ country due to the high share of intercompany loans, which we regard more as equity than debt.

How strong is the FX pass-through?

FX pass-through is high, particularly in the very open Central European economies. Second-round effects amount roughly to one-third of the total pass-through. The CNY pass-through is quite low in CEE, but the Czech Republic and Poland are exposed to the risk of importing disinflationary pressures from China, mainly though prices of clothing and textiles.

How dependent on autos?

The combined CE-5 (Poland, Hungary, the Czech Republic, Slovakia and Romania) is the second-largest car producer in Europe, with 3.7 million vehicles per year (Germany is top, with 5.9 million).

To truly understand how much value-added is created, we need to decompose exports into domestic and foreign value-added: for example, the share of imported goods for one unit of exports in the sector could reach as much as 60% in Hungary and Slovakia.

How important are EU funds?

EU funds have been helping convergence, and will likely continue to do so. Absorption rates vary widely across the region, with Poland being particularly efficient between 2007-13.

In the 2014-20 budget, CEE/SEE countries have received a higher overall nominal amount, though most likely this will be lower as a percentage of projected GDP over that period. The upshot is that these funds have not yet exhausted their role as a driver of convergence, though we will see a slowdown in 2016. For example, in Hungary EU funds absorption this year should be around 3.5% of GDP this year, after over 7% in 2015.

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