Seb Eastern Europe Outlook Seb_eeo_10_2008

ECONOMIC RESEARCH

•

ENGLISH EDITION

Eastern European Outlook Theme: Russia after the elections Resilience eroding

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OCTOBER 2007 2008 OCTOBER

SEB Economic Research Eastern European Outlook - October 2008

Eastern European Outlook is produced twice a year. This report was published on October 8, 2008. It was written by Mikael Johansson (Chief Editor), Ruta Eier, Bo Enegren, Dainis Gaspuitis, Gitanas Nauseda, Mats Olausson, Vilija Tauraite, Nerijus Udrenas och Andris Vilks. Robert Bergqvist, Chief Economist, [email protected]

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Mattias Bruér, Economist, [email protected]

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Ingela Hemming, Small Business Economist, [email protected]

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Mikael Johansson, Economist, Head of CEE, [email protected]

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Erik Lindmark, Small Business Analyst, [email protected]

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Gunilla Nyström, Global Head of Personal Finance Economy, [email protected] Fax no.

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SEB, Economic Research, K A3, SE-106 40 STOCKHOLM Mats Olausson, Chief Strategist, Emerging Markets, TCM

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Ruta Eier, Economist, SEB Eesti Ühispank

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Andris Vilks, Chief Economist, SEB Latvijas Unibanka

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Summary Eastern European Outlook — October 2008

The resilience of Central and Eastern Europe in the face of global economic slowdown is on its way towards eroding. Until now, many countries have maintained their growth thanks to vibrant domestic economies, with growing investments and consumption. Today, however, pressure on the region’s economies has greatly increased as the euro zone has stagnated and the repercussions of the international financial and credit market crisis intensify. We are adjusting our overall growth forecasts downward, and Central and Eastern Europe can no longer be viewed as a “strong growth region”. GDP growth in the nine countries covered in Eastern European Outlook will fall from an average of 7.4 per cent in 2007 to 6.0 per cent this year, 4.5 per cent in 2009 and 4.8 per cent in 2010. Russia and Poland stand out with continued decent growth but risks are skewed to the downside. Inflation will fall in most countries, but the downturn will be sluggish in Russia and Slovakia. Countries with large external imbalances – the three Baltic countries and Ukraine – are the most vulnerable to tighter global credit conditions. Credit growth is clearly slowing from a high level in Ukraine and will fall somewhat further in the Baltics, which are undergoing a continued adjustment after their overheating. Russia’s economic deceleration will be moderate. The reasons are large federal budget and current account surpluses and the ability to respond to lower demand with a more expansive fiscal policy. We are also assuming a moderate cool-down in commodity prices. The risk of major failures in the banking sector is mainly linked to small and medium sized banks. Ukraine’s economic outlook has become quickly and noticeably gloomier, after several years of strong expansion. Overheating problems are not being resolved, due to continued political instability and deteriorating terms of trade. In Estonia the recession will be lengthy; GDP will fall again in 2009 and the labour market will deteriorate noticeably. Home prices will continue to fall, bottoming out only late in 2009. Wage-driven inflation will fall rapidly. In Latvia, too, the downturn will be long-lasting. Consumption and investments will remain weak. Unemployment is on the way up, and home prices will continue to fall in 2009. The country’s large current account deficit will shrink quickly but remain at a high level Lithuania is beginning a gradual, domestically driven slowdown. Growth will be weak in the next couple of years. The current account deficit and inflation will remain stuck at high levels, partly due to the closing of the Ignalina nuclear power plant in 2009. Poland will experience a soft landing. Underlying economic strength and the modest scale of the imbalances the country has built up point towards relatively good economic performance. The government’s new target of a transition to the euro by 2011 seems a year too optimistic. Its ambitions will dominate economic policy, which will be relatively tight. Looking ahead, this will provide support to the zloty. Slovakia, the Czech Republic and Hungary will all be relatively hard hit by the euro zone slowdown; they are more export-dependent than Poland. Growth in Slovakia and the Czech Republic will halve. Hungary is slowly recovering after its earlier period of tough belttightening policies.

3

The international economy Eastern European Outlook — October 2008

For Central and Eastern Europe, the international economic picture is thus substantially gloomier than we foresaw last spring. Compared to Eastern European Outlook in March, we have adjusted our 2009 growth forecast for the euro zone – a vital export market for the countries to its east – downward by 1.2 percentage points.

Global recession in 2009 n n n

Synchronised economic slowdown Inflation on the way down Central banks will cut key interest rates

The global financial market crisis continues to have a negative impact on economic performance. Credit conditions have tightened in the wake of major new losses in the banking system and dramatically wider interest rate spreads between safe and less safe securities. Although we expect the exaggerated spreads between mortgage bonds and government bonds to shrink after the passage of a giant American financial rescue package, the process of adjustment to a more normal situation risks being prolonged. It may last until well into next year. A deeper economic slump and continued home price declines in the US during the first half of 2009, as well as the emergence of banking crises in Europe, will be obstacles along the way. Credit conditions will thus be tough for another while. This will, in turn, hamper the real economy.

Interest rate cuts on a broad front Inflation pressure will diminish as commodity prices continue to soften and the increasingly synchronised economic slowdown gradually increases the downward pressure on wages and prices. For example, average euro zone inflation will fall from 3.5 per cent this year to 2.3 per cent in 2009. Given our forecast, next summer the year-on-year inflation rate will have dropped to levels consistent with the European Central Bank’s inflation target of just below 2 per cent. The ECB’s concern about inflation will ease due to weaker economic performance. The bank will begin cutting its key interest rate during the autumn. It will slash the refi rate from 4.25 per cent to 3.25 per cent next year, followed by further cuts in 2010. Sliding home prices and paralysed demand in the United Kingdom will persuade the Bank of England to cut interest rates more aggressively. The British repo rate of 5 per cent will be lowered starting in October, reaching 3.5 per cent by summer 2009. The US Federal Reserve will lower its fed funds rate from 2 to 1 per cent in the next six months. If tensions in credit and finance markets should become even more severe, joint actions including sharp interest rate cuts cannot be ruled out.

GDP growth Year-on-year percentage change

United States China

2007

2008

2009

2010

2.0

1.5

-0.3

1.5 8.0

11.9

10.0

8.0

Euro zone

2.7

1.2

0.3

1.2

United Kingdom

3.1

1.0

-0.5

1.3

Nordic countries

3.0

1.7

1.0

1.8

OECD

2.7

1.3

0.1

1.3

The world

5.0

3.6

2.6

3.2

We expect long-term government bond yields to show modest movement in the coming year, although shortterm fluctuations may be significant. On the one hand, central banks will be cutting interest rates as inflation falls, which points towards lower long-term yields. On the other hand, there will be an increased supply of government bonds due to rising budget deficits, especially in the US, which will counter a downturn.

Sources: OECD, SEB

The world economy will thus lose further momentum after very high growth in recent years. In 2009, growth in the OECD countries will be lower than in the early 1990s, because the economic slump is spreading in earnest from the US to Western Europe and Japan. To date, growth has remained good in much of Asia and Central and Eastern Europe. But now secondary effects from the OECD slowdown are becoming more widespread while a number of countries are struggling with persistent inflation problems.

Looking ahead, the dollar will enjoy support due to expectations of earlier economic recovery in the US than in Europe, as well as the resulting earlier interest rate hikes. We expect the EUR/USD exchange rate to stand at 1.30 in a one-two year perspective. We expect commodity prices to fall somewhat further, due to ever weaker global economic prospects. For example, we are assuming that oil prices (Brent) will average USD 80-90 per barrel next year.

Overall, the global economy will grow by 2½ per cent in 2009, measured in purchasing power-adjusted terms. This is what the International Monetary Fund nowadays defines as a recession at the global level. A clear recovery in the world economy will take time to materialise. Due to credit market problems combined with delayed economic policy responses in Western Europe, growth there will end up well below trend in 2010 as well.

4

Russia Eastern European Outlook — October 2008

Lower commodity prices hurt sentiment

Decent resilience n n n n

Theoretically, the oil price downturn should not make so much difference to real growth, since variations in oil prices primarily affect federal government savings in the Stabilisation Fund via extremely high taxation of oil income. This means that pay and profits are not affected especially much, as long as the thrust of fiscal policy remains unchanged. Despite expenditure increases in recent years, the federal budget would show a balance even if oil prices fell to USD 60-65 per barrel. Yet it is reasonable to assume that future expectations of both households and companies are affected. For example, household saving is likely to be higher if federal government saving decreases. This will curb the appetite for borrowing, at the same time as lending practices become more restrictive.

Strong but decelerating consumer growth Lower commodity prices hampering expansion Inflation will fall slowly Twin surpluses are shrinking

Russia is coping relatively well with international credit market turbulence, but a slowdown in growth is also happening here. Aside from tighter credit conditions, other factors behind this deceleration are lower commodity prices and certain capacity constraints. GDP will grow by 7.0 per cent during 2008 as a whole, after last year’s 8.1 per cent increase. Next year, growth will slow further to 5.6 per cent, in line with the level usually stated as Russia’s trend growth rate. The risk in the forecast is skewed to the downside and is associated with more serious effects of the financial crisis and a larger downturn in commodities. Fiscal policy will gradually become less expansionary, but if the downshift in growth should be larger than we have anticipated, there is both willingness and room to ease fiscal policy again.

The global financial crisis has reached Russia during the autumn. The liquidity crisis has developed into a crisis of confidence. The authorities have acted resolutely with the support of a large financial buffer. While the crisis may deepen further we believe the risk of major failures in the financial sector seems relatively small. Russia’s banking system is dominated by a few financially sound banks, several of them with large state ownership, making it possible to use the large financial resources of the Russian federation to recapitalise large banks that run into problems. There are also numerous small and medium-sized banks that are less well equipped. The credit crisis will probably accelerate the consolidation of the financial service industry.

Growth will continue to be driven by domestic demand, while capacity restrictions and real appreciation of the rouble will hold down exports. Russia’s large federal budget and current account surpluses will gradually shrink as oil prices fall to USD 80-90 per barrel during our forecast period. Russia: GDP and inflation

Continued slowdown in growth

Year-on-year percentage change 9

Second quarter GDP growth was 7.5 per cent, or clearly above trend, yet this represents a downshift from the two preceding quarters, with growth rates of 9.5 and 8.5 per cent, respectively. As earlier, growth on the output side was mainly driven by domestically oriented sectors such as distributive trades, while manufacturing output rose at a more modest pace. The downward trend in oil output growth continued, and today output is also falling in absolute terms. On the demand side, consumption is the main growth engine, but investments have also increased sharply, although there has been a clear cool-down in recent months. We expect consumption to remain the most important driving force behind demand, among other things supported by continued good real wage increases and some support, albeit fading, from fiscal policy. The new middle class will continue to be an economic engine, through greater consumption but especially as a producer of various new services.

16 SEB forecast

8 7

14 12

6

10

5

8

4

6

3 2

4

1

2

0

0 02

03

GDP (LHS)

04

05

06

07

08

09

10

CPI (RHS) Sources: Rosstat, SEB

Lower commodity prices have contributed to a sharp decline in the Moscow Stock Exchange since its peak last summer. Considering that share ownership in Russia is not especially widespread, however, this is hardly likely to have any wealth effects on consumption worth mentioning. Financing of companies via the stock market is not of crucial importance to investments, either. About 50 per cent of corporate investments are financed via internal cash flows, an indication that the financial sector is still relatively undeveloped.

Large-scale federal spending on infrastructure will sustain investments in the next few years. Meanwhile we expect certain negative effects from the tighter credit situation on private capital spending. Another

5

Russia Eastern European Outlook — October 2008

constraint, especially in the construction sector, is high capacity utilisation. New housing starts, for example, are rising at a substantially slower pace than before, indicating a deceleration in residential construction. Although large investment projects may contribute to increased overheating problems in the short term, boosting the investment level is vital to growth in a somewhat longer perspective, especially in light of Russia’s negative demographic trend.

High underlying price pressures Despite some deceleration in recent quarters, the economy is still growing above potential. Among the results are higher resource utilisation and a larger proportion of demand being satisfied via increased imports. Various types of bottleneck problems have become increasingly apparent. In places, labour shortages are also an obstacle to expansion, especially in Moscow and St. Petersburg, where unemployment is close to zero. Due to relatively low geographic mobility, competition for labour in these areas is driving up pay, which is currently increasing at about 30 per cent annually. Real wage growth has been substantially higher than productivity for several years. Due in part to higher resource utilisation, underlying inflation has moved upward in the past year, but the most important reason for the doubling of CPI inflation since early 2007 is sharp food price increases. Since food accounts for 40 per cent of the consumption basket, these hikes have had a strong impact on CPI.

Russia: Oil output and prices Year-on-year percentage change USD/barrel 15.0

130

12.5

110

10.0

90

7.5

70 5.0

50

2.5

30

0.0

10

-2.5 01

02

03

Oil output (LHS)

04

05

06

07

08

Russia: Pay, CPI, and M2 money supply Year-on-year percentage

Oil price, Ural (RHS) Sources: Federal State Statistics Service, Reuters EcoWin

60 55 50 45 40 35 30 25 20 15 10

The trend towards stagnating or slightly falling oil output will probably continue. Many oil fields are nearing depletion, while few have been added in recent years. Insufficient investments are one reason for this, which in turn may be partly related to unclear rules of the game for foreign companies and uncertainty about the role of Russia’s government. Another reason is the high tax burden. However, oil sector taxation is currently being re-assessed, including proposals for tax exemption during the first year of offshore production. New legislation on strategic sectors, including gas and oil, has removed some of the uncertainties about the rules for foreign companies. The government has also recently boosted its appropriations for prospecting, but ensuring production growth in the medium term will require gigantic investments, since new discoveries are often located far from developed infrastructure. It is also worth observing that while Russia is indeed the world’s second largest oil producer after Saudi Arabia, the country’s known oil reserves are only the seventh largest in the world.

30.0 25.0 20.0 15.0 10.0 5.0 04

05

06

M2 (LHS) Wages and salaries (RHS)

07

08

CPI (RHS)

Sources: Federal State Statistics Service, The Central Bank

Since last spring, the inflation rate has been relatively steady at around 15 per cent. We expect a slight decline via lower contributions from food and energy, but judging from producer price trends, for example, the downturn is likely to be moderate in the short term. Looking somewhat further ahead, lower international prices and probably also reduced inflows of foreign capital will help ease price pressure. Working in the opposite direction will be various planned hikes in prices and fees over the next few years, for example gas and electricity. Overall, we expect inflation to average slightly below 14 per cent this year and fall to slightly more than 11 per cent next year.

Since growth in oil and gas output is so weak, this will eventually squeeze export income, especially with prices now on their way down. Oil and gas account for more than 60 per cent of the country’s export income, about 20 per cent of GDP and 45 per cent of federal government revenue. The easiest way for Russia to increase, or rather maintain, its level of energy exports is to reduce its high domestic energy use. This is also the purpose of the ongoing deregulation of the energy sector and plans for market adjustment of gas prices for domestic users by 2011.

Direction of rouble less obvious The central bank has repeatedly failed to achieve its inflation target. One reason is that the bank has simultaneously had an exchange rate target. The primary reason behind this target is that Russia wants to avoid excessively rapid appreciation of the rouble, which jeopardises businesses outside the commodities sector that are exposed to international competition. In recent

6

Russia Eastern European Outlook — October 2008

ment is a mix of liberals and tougher individuals, but it seems as if the liberal wing has been strengthened somewhat. President Dmitry Medvedev has also been perceived as relatively liberal and business-friendly, due to his clear focus on reducing corruption and bureaucracy and strengthening the rule of law, but a number of events during the summer fuelled uncertainty about government policy. The escalation of the conflict between BP and its Russian partners in the jointly owned company BP-TNK again focused attention on conditions governing foreign companies. Putin’s criticism of pricing policies by the Mechel coal and steel company led to strong reactions in the stock market. The military conflict in Georgia further damaged investors’ faith in the predictability of Russian policies. Strong market reactions to the summer’s events probably came as a surprise to the government and may have served as an alarm clock, which in turn might lead to improvements in the investment climate.

years, the central bank has allowed nominal appreciation averaging about two per cent annually against a basket consisting of 55 per cent dollars and 45 per cent euros. This reflects the trend against the dollar, while the rouble has weakened against the euro. Since more than 60 per cent of imports come from the EU and only 3 per cent from the US, this has helped to drive up import prices. During the spring and summer, the central bank moved cautiously to tighten monetary policy, mainly by boosting reserve requirements. The bank’s most important interest rate has remained sharply negative in real terms. In the spring, the bank announced plans to allow larger rouble exchange rate movements to make it harder to foresee short-term fluctuations and thereby counter speculative capital inflows. The goal is that starting in 2011, monetary policy will be managed only on the basis of an inflation target. Until then, the central bank will continue to base its exchange rate policy on a dollar/rouble basket.

Who’s in charge?

The external conditions for central bank policies changed drastically when the credit crisis reached Russia in earnest late in the summer. Capital inflows were replaced by outflows due to falling commodity prices, increased political uncertainty and general global credit market turmoil. The situation was exacerbated in part by large tax payments and the need to refinance relatively large foreign loans during the autumn. The strategy of Russian authorities for attacking the credit crisis was to furnish the large banks, which are pivotal to the financial system, with liquidity. In addition, all banks received support via a lowering of reserve requirements. The ministry of finance also undertook stepped up oil surplus auctions. Among other measures being undertaken are lower taxation of oil exports, a more flexible VAT payment system, higher government bank deposit guarantee limits as well as earmarking of funds for possible repurchase programmes in state-owned companies. Despite official auctions, small and medium-sized banks are still in a very strained situation.

Various contradictory statements by the president and prime minister related to the Georgia conflict have also fuelled speculation about the division of power between Putin and Medvedev. The combination of a president with strong formal powers and a prime minister with significantly less formal power but very strong informal power by virtue of his dominant personality implies uncertainty as to where real power lies. According to public opinion surveys, a clear majority of the Russian public believes that Putin is still in charge. So far, there have been no external signs of a split between the two. However, it remains unclear whether Putin sees his role as gradually ceding power to Medvedev while the latter builds up his own power base, or whether Putin is planning a comeback as president by winning the 2012 presidential election. As for the consequences of increased tensions with the West and the Georgian conflict, they may further delay future World Trade Organisation membership. However, due to ever-increasing mutual dependence between Russia and the EU in economic, financial and energy-related terms, there are major incentives on both sides to limit tensions. The powerful reactions to Russia’s foreign policy actions, especially in financial terms, also serve as a moderating factor, since the country’s political leaders are not unaffected by the dissatisfaction of various economic interests with these developments.

The rouble weakened by more than 3 per cent in August and September but then recovered marginally. Even if the rouble recovers some lost ground ahead, appreciation pressure will probably fade gradually as Russia’s current account surplus falls. Our assessment is that the rouble will then again weaken.

Increased political risk The presidential transition last spring was just as undramatic as one could expect. Two thirds of Prime Minister Vladimir Putin’s government, which was unveiled in mid-May, consists of members of the previous government. The remaining members are mainly people that Putin brought with him from his own presidential administration. As earlier, the govern-

7

Ukraine Eastern European Outlook — October 2008

ports will once again be squeezed as demand weakens further in major customer countries in Europe. Weaker production will also have an impact due to a diminished need to expand capacity, which will restrain capital spending. Increasingly tough lending practices will have a similar effect ahead. There has already been a clear deceleration in construction due to the housing market slowdown, and this trend will intensify in the coming year.

Gloomier outlook n

n

n

Decelerating credit growth – weaker domestic demand Record-high inflation will slow – but will remain in double digits Less favourable terms of trade will lead to larger current account deficits

There has been a noticeable deceleration in credit growth from a rate of nearly 80 per cent early this year to less than 60 per cent in recent months. This trend will be accentuated as banks become more cautious about their lending, in the wake of the global credit crisis. The Ukrainian consumption boom will thus lose momentum and slow to more sustainable levels.

After several years of vigorous expansion in the Ukrainian economy, the growth outlook is now deteriorating. There will, of course, be continued strong potential for catch-up-driven growth and for greater integration in the world economy. Meanwhile, however, the country’s overheating problems have intensified, as manifested in its rising current account surpluses and record-high inflation. Recurrent government crises have led to the postponement of important structural issues, and fiscal policy has become increasingly pro-cyclical. Ukraine’s deteriorating external balance and greater private debt abroad is increasing the country’s vulnerability in the shadow of the global credit crisis.

Ukraine: Current account balance USD billions

Ukraine now faces an adjustment to a more sustainable economic trend. Due to weaker credit growth ahead, domestic demand will decelerate, while exports will be hampered by weaker competitiveness and deteriorating international economic conditions. GDP growth will fall from 6.3 per cent this year to 3½ per cent in 2009 and then recover somewhat to 4½ per cent in 2010. 1000

1200

900

1100

800

1000

700

900

600

800

500

700

400

600

300

500

200

400

100

300

Jan

Jul Oct Jan Apr Jul 07 08 PFTS (LHS) 5-year credit default swaps, CDS (RHS)

2

2

1

1

0

0

-1

-1

-2

-2

-3

-3 -4 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 Source: National Bank of Ukraine

Due to the slowdown in domestic demand, extremely excessive growth in imports will gradually decelerate. This does not imply any improvement in the trade balance, however, since we meanwhile expect a clear deterioration in Ukraine’s terms of trade. After the recent very favourable trend, especially for steel prices, we expect a slowdown ahead, in line with other commodity prices. Meanwhile import prices will climb when Russia boosts natural gas prices at the beginning of 2009. According to widely circulated information, these prices will more than double. The final outcome will be a matter of negotiations, and it is possible that Ukraine may escape with a smaller price hike. To some extent, it can offset price hikes by raising transit fees. If the increases should amount to 100 per cent, this means that the value of imports would increase by about 5 per cent of GDP in 2009. Although the price hikes may be lower, we are expecting a current account deficit of 7.5 per cent of GDP this year and 10 percent in 2009.

0

Apr

3

-4

Ukraine: Stock market and CDS price 1300

3

Oct

Source: Reuters EcoWin

In recent months, growth has become increasingly imbalanced, including slowdowns in exports and investments as well as in consumption, which accounts for an ever-larger proportion of demand. Meanwhile import growth has accelerated, partly a reflection of weaker competitiveness, despite the fact that the hryvnina has largely followed the weakening dollar in recent years. Although there will be a slight rebound due to a bountiful agricultural harvest, ex-

Despite its poorer current account outlook and the uncertain situation in global finance markets, Ukraine attracted large capital inflows during the first half. Among other things, foreign direct investments rose by 40 per cent compared to the same period of 2007.

8

Ukraine Eastern European Outlook — October 2008

mentary election in as many years. Judging from public opinion surveys, the Timoshenko Block would make major gains in a possible early election. Support for Yushchenko and Our Ukraine has collapsed and is now only about 5-6 per cent. Weak public support for the President and Our Ukraine indicates that the party has very little to gain from a snap election and might thus be willing to conclude a new agreement with the Timoshenko Block.

Given the recent sharp deterioration in risk appetite, however, this favourable trend is rather unlikely to continue. FDI inflows are also being hampered because the government has postponed privatisation plans for the time being. With foreign debt having grown relatively quickly, from about 45 per cent of GDP in 2005 to 60 per cent last year, financing requirements will increase in the future. Inflation culminated in May at above 31 per cent but slowed to 26 per cent in August. Considering that food makes up half the CPI consumption basket, inflation in Ukraine has been greatly influenced by the food price trend. Meanwhile there is strong underlying inflation pressure in the economy, with wages and salaries rising about 35-40 per cent. In addition, fiscal policy has been clearly pro-cyclical, among other things via sharply higher transfer payments. Looking ahead, we expect inflation pressure to continue easing gradually. Reduced price pressure from food and gradually slower pay increases as the economy decelerates will contribute to this. Meanwhile there is a pent-up need to raise various charges and fees. The sharp price increases for gas are another reason why the downturn will occur gradually. Our assessment is that inflation will average nearly 26 per cent this year and fall to 16 per cent in 2009.

Another conceivable solution to the crisis is for the Timoshenko Block to form a broad coalition with the pro-Russian Party of Regions. Timoshenko’s low profile during the Georgia conflict and improved relations with Russia have undoubtedly made it easier for such a constellation to take shape. Regardless of how the current crisis ends, however, the potential for a strong government will not be especially good until the presidential election early in 2010, since the issue of the division of power between the president and parliament remains unresolved. Added to this domestic political turbulence is greater uncertainty in relations with Russia, triggered by the crisis in Georgia. Although the parallels between the break-away regions of Georgia and the situation in the Crimea are misleading in many respects, increased tension in the region is a further uncertainty factor. It is not obvious what the economic consequences of this uncertain political situation may be. Instability in Ukrainian domestic politics is nothing new, although the situation has deteriorated in recent months. Yet economic growth has remained strong and foreign investments have continued to flow into the country. One possible reason is that despite Ukraine’s messy politics, there is relatively broad consensus about such fundamental matters of policy as closer relations with the EU, WTO membership (Ukraine became a member this year) and key elements of reform policy. However, there is now a risk that politics will have a more negative impact on the economy ahead. Due to domestic political disunity, fiscal policy has become increasingly pro-cyclical, thereby worsening the overheating in the economy. A continuation of the constitutional conflict on the division of power between Parliament and president will also be a growing obstacle to the implementation of important reforms.

The National Bank of Ukraine has relatively limited means for combating inflation, since monetary policy focuses chiefly on maintaining a fixed exchange rate against the dollar. Since last summer, the bank has aimed at keeping the hryvnia in the UAH 4.65-5.05 range against the dollar, with a benchmark rate of 4.85. The central bank has also signalled that it will gradually shift towards maintaining an exchange rate against a basket of currencies. At first the hryvnia traded in the stronger portion of its band, very much due to continued strong capital inflows, but during the turbulence of recent weeks, the rate has weakened clearly. Our assessment is that the hryvnia will weaken further against the dollar as a consequence of rising current account deficits and reduced capital inflows. By the end of 2009, the exchange rate against the dollar will be 6.50.

Politics getting even messier There have been recurrent political crises in recent months. In June, two defections from coalition parties caused the government to lose its parliamentary majority, but a later court ruling declared these defections unconstitutional. Meanwhile the conflicts between Parliament and President Viktor Yushchhenko on constitutional reform have escalated. When Prime Minister Yulia Timoshenko joined forces with the opposition in order to curb presidential power, Yushchenko’s party Our Ukraine pulled out of the government. A snap election is thus moving ever closer, only a year after the last one. It would be the third parlia-

9

Estonia Eastern European Outlook — October 2008

Early in 2008, several additional external shocks hit the economy, including skyrocketing oil prices and decelerating global growth, while transit trade fell 40 per cent below the year-earlier level. These developments finally drove Estonia into recession. As a consequence of additional shocks, by mid-2008 the economic downturn had become very widespread, affecting not only domestic demand but also such key export sectors as wood, furniture and textiles.

Lengthy recession ahead n n n

Home prices are continuing to fall Domestic demand remains depressed Inflation will rapidly come down

Since the second quarter of 2008, Estonia has slid into recession. There seems to be relatively little chance of avoiding a lengthy period of negative growth. In 2009, global financial and economic stress will leave its mark on Estonia. In addition to obvious pressure on exports, an equally crucial effect will be via monetary conditions, which will tighten. Domestically, the adjustment has been slower than expected, with remarkable inertia in the labour market and prices. Next year, the government will also boost several VAT rates. That means that the correction will take longer than previously thought and major shifts are expected to happen only in 2009, further prolonging the recession. In 2009, negative GDP growth will continue, averaging minus 2.2 per cent. In 2010, growth will recover to plus 2 per cent.

Meanwhile other export sectors like metals, chemicals and machinery production were performing quite well. Even in construction, value-added remained positive, despite the freezing of several construction projects in 2008 due to oversupply in the real estate market. Construction was sustained by public sector and commercial property projects, which will not be there any more in 2009. Because so many projects were being built, as of mid-2008 no decrease of employment in the construction sector had occurred. In June, overall unemployment stood at an all time low, 4 per cent. However, vacancies have been declining since late 2007. A rise in the jobless rate is expected during the second half as the manufacturing sector shrinks. Wage growth slowed from 19 per cent year-on-year in the first quarter of 2008 to 15 per cent in the second quarter and should moderate to an average of about 8 per cent in 2009. Jobs will also disappear in the public sector during the second half of 2008 due to expenditure cuts. This means that unemployment will increase not only in the blue-collar segment but also the whitecollar segment. Unemployment will not climb sharply, however, since the labour market remains rather tight and some of the people who are laid off can be employed in other sectors.

A lengthy recession combined with marked losses of competitiveness implies a risk of currency adjustment. In our new, darker economic scenario, with a more substantial increase in unemployment this risk has risen despite the government’s tightening measures. Weaker prospects for exports imply that the return to sustainable current account deficit (5-7 per cent of GDP) will take a longer time. But our main scenario is still that Estonia’s exchange rate peg will survive. A substantial share of loans in the private sector is denominated in euro. Therefore the costs associated with a devaluation are large. Consequently we expect that the authorities will go very far in order to preserve the currency pegs. The same argument goes for Lithuania and Latvia.

The longer the recession lasts, the more likely it is that some companies will not survive the pressure. This situation will culminate in 2009, whereas in 2008 most companies can still rely on savings and other assets accumulated during previous boom periods.

The economic slowdown started with a gradual deflation of the real estate bubble from mid-2007 onward. A year later, the average price of flats had fallen 15 per cent, and in Tallinn 19 per cent.

Tighter credit conditions The global credit crunch will mean less capital inflow and higher interest rates. The massive expansion of cheap credit that fuelled the rapid growth of recent years will be replaced by very cautious lending practices and higher interest margins. Tighter credit supply will constrain real estate and other investments and favour companies in good financial health.

Estonia: Property prices EEK per square metre, year-on-year % change 30000

70

25000

50

20000

30

15000 10 10000

Home prices will continue downward in 2009 as financing conditions remain tight, consumer confidence is low and the real estate oversupply persists. We expect residential investments to decline in 2009. The fall in real estate prices will help prolong the economic slump. We expect prices of flats to bottom out at 25 per cent below their peak late in 2009.

-10

5000

-30

0 Q3 Q1 Q3 03 04

Q1

Q3 05

Q1

Q3 06

Q1

Q3 07

Q1 08

Tallinn, price (LHS) Estonia, price (LHS) Tallinn, change (RHS) Estonia, change (RHS) Source: Estonian Land Board

10

Estonia Eastern European Outlook — October 2008

teracted by an increased willingness to export. During 2006-2007, some companies focused on the domestic market, profiting from rapid price increases and the consumption boom. This was one reason why export growth rates fell earlier than foreign demand.

Non-residential property investments will also remain below trend, reflecting tighter credit conditions and low confidence. In 2008, profits were hurt by rapidly increasing input costs and decelerating sales. In 2009, sales will still be depressed, but input costs will fall as a looser labour market slows wage growth. Oil prices will have peaked in 2008.

The Baltics: Real effective exchange rate Index 2000=100

Falling prices of homes and other assets will reduce household wealth and keep down consumption. Despite rapid wage growth deceleration, the pace of real personal income growth should remain positive, though modest, since inflation will also fall at a rapid pace. However, consumption will slow due to deteriorating confidence and higher unemployment. With domestic demand suppressed and wage inflation slowing markedly, there will be far less inflation pressure ahead. Estonia’s major indirect tax hikes took place in 2008, setting the stage for lower inflation, but the government’s latest budget bill proposes VAT increases on such items as medicines, books and concert tickets. Also, electricity prices will increase. Import price increases have peaked, and lower oil prices, the inflation rate will slow to 5.0 per cent in 2009 and 3.5 per cent in 2010.

30 20 10 0

2

-10

1

110

105

105

100

100

95

95

90

90 85 01

02

03

Estonia

04

05

06

07

08

Lithuania

Fading inflation pressure will help lay the groundwork for economic recovery in 2009 but will probably be not sufficient to counteract diminishing external demand. Another growth-supporting factor will be service exports. Although the global slowdown will lower the demand for services, they are less cyclical.

40

3

115

110

Meanwhile high domestic price increases and appreciation of the currency (the real effective exchange rate climbed) undermined competitiveness, and productivity growth lagged. Over the next few years, one main task for exporters will be to bring their productivity growth back in line with wage growth. Reducing the labour force will be one part of this process.

50

4

120

115

Source: BIS

SEB forecast

5

125

120

Latvia

60

6

130

125

00

Estonia: Growth in export markets and exports 7

135

130

85

The government is continuing to aim at a balanced budget and will therefore cut various planned expenditures in the next few years. It plans to freeze public sector pay, trim operational expenses and cancel certain investments, especially property-related ones. Despite a much slower increase in government spending in 2009 than previously, tax revenue is likely to be insufficient to meet expenses. We thus expect a deficit. 8

135

-20 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

Weighted average, growth in main export markets (LHS) Estonian export growth (RHS) Sources: Reuters EcoWin, SEB

Exports crucial for recovery During 2009, the only way Estonia can climb out of its recession will be through exports, and the fundamental question here is competitiveness. Due to rapidly decelerating external demand, export growth had already shrunk to almost zero by mid-2008, and we expect a further slump. This decline might be coun-

11

Latvia Eastern European Outlook — October 2008

and the economy was mainly driven by exports. For the fifth consecutive quarter, there was clear downward trend in manufacturing and retailing. Support from construction, transit trade and commercial services was also weaker than expected.

Recession ahead Plummeting demand will help dampen imbalances Tighter fiscal policy but export stimulus Weak real wage growth in 2009

n

n n

Foreign debt Per cent of GDP

After three years of double-digit GDP increases, leading to an overheated economy, Latvia is now experiencing a slump in domestic demand. Growth has almost vanished. This is partly connected to tighter credit conditions and global financial turmoil. Negative GDP growth is a certainty during the next several quarters. Stagnating demand in the euro zone and troubled world financial markets will have a dampening effect on Latvia’s economic recovery. Furthermore, fiscal policy will be tightened. We have thus substantially revised our previous GDP forecast downward to minus 0.5 per cent this year, minus 2.0 per cent in 2009 and expect plus 2 per cent in 2010. The sharply cooling economy will help dampen the country’s long lasting imbalances. The large current account deficit will continue to shrink relatively quickly. Inflation will wane substantially due to the recession.

100

90

90

80

80

70

70

60

60

50

50

14

8 4 4

0

02

03

GDP (LHS)

04

05

06

07

08

09

04

05

06

07

08

Estonia

0.7125 0,7100

0 01

03

0.7125

2

-2

02

Exchange rate EUR/LVL

6 2

40 01

The government’s plan to cool the economy, presented in the spring 2007 after a period of currency turmoil, proved ineffective. It was implemented very selectively and with long delays. One important goal of this “anti-inflation plan” was to bring down unsustainably high private sector credit growth. Meanwhile such external factors as rising energy and food prices and the global credit crunch increased the risk of a hard landing. Economic sentiment indicators dropped to levels not seen since the early 1990s. In 2007, the real estate bubble burst. Home prices have fallen 35 per cent from their peak. We expect a further 20 per cent correction by 2009 before the market stabilises.

10

6

110

100

Source: Reuters EcoWin

12

8

120

110

Latvia

16

10

130

120

00

Year-on-year percentage change SEB forecast

140

130

40

Latvia: GDP and inflation 12

140

10

0.7100

0.7100

0.7075

0.7075

0.7050

Inflation (RHS)

0.7050 0,7028 ± 1%

Sources: Statistics Latvia, SEB

Looking ahead, due to global financial turmoil the Latvian economy, with its elevated foreign debt, will face tightening financing, which may lead to speculation about the stability of the currency. Despite a continued decline in external imbalances, we see a lingering exchange rate risk. In our new recession scenario this risk has increased, although we still assume that Latvia and the other two Baltic countries will maintain their exchange rate pegs. The risk of an exchange rate adjustment (devaluation or freely floating currency) seems greatest in Latvia, followed by Estonia.

0.7025

0.7025

0.7000

0.7000

0.6975

0.6975

0,6960

0.6950

0.6950

0.6925

0.6925 05

06

07

08 Source: Reuters EcoWin

Surprisingly, today’s sluggish growth has not yet been reflected in the labour market. On the contrary, in the second quarter job growth continued. Unemployment fell to 6.3 per cent, mainly due to more active jobseeking in anticipation of the coming recession. However, a sharply decreasing number of vacancies and expected workforce reductions in both the private and

The growth rate plummeted from stable double-digit figures to almost zero in the second quarter of 2008. Both private consumption and investments declined,

12

Latvia Eastern European Outlook — October 2008

growth. Foreign direct investments into Latvia remained stable in the first half of 2008. Four fifths of the second quarter current account deficit was covered by long term capital, of which 58 per cent was FDI.

public sector will push unemployment up to 9 per cent next year. Nominal wage and salary growth slowed to 24 per cent in the second quarter from above 30 per cent as recently as the fourth quarter of 2007. This deceleration can partly be explained by intensive efforts last year to legalise wages and salaries in the informal economy. Pay increased have slowed both in the private and the public sector. We expect nominal wage growth to decline to 9 per cent next year, resulting in negligible real wage growth.

The budget will be tightened Overly optimistic budget planning forced the government to abandon its goal of achieving a public budget surplus of 1 per cent of GDP in 2008. Prime Minister Ivars Godmanis, who has extensive experience from the tough reforms of the early 1990s, is playing a key role in efforts to tighten spending in 2009. To ensure that the budget deficit is as small as possible, he is calling for such measures as a pay freeze in the public sector and a reduction in the number of public employees.

Latvia: Consumer confidence and retail sales 5

40

0

30

-5

20

-10

10

-15

0

-20

-10

-25

-20

-30

-30

-35

During the summer the government tried to force all state institutions to cut their planned costs. However, these plans had to be shelved. The current budget proposal for 2009 projects a deficit of 1.85 per cent of GDP and will be decided by Parliament in October. The major labour unions are upset with the proposed freeze on public sector salaries, and passage of the budget will depend on trade-offs between the unions and the Godmanis cabinet. The prime minister is determined to cut the number of public employees by 10 per cent in 2008-2009. Despite these severe cost cutting measures, the government is unlikely to escape fiscal deficits this year and next. Our forecast is that the deficit may reach 1.5 per cent in 2008 and 3 per cent in 2009, thus touching but not exceeding the Maastricht Treaty limit.

-40 02

03

04

05

06

07

08

Consumer confidence, net balance (LHS) Retail sales, year-on-year percentage change (RHS) Sources: DG ECFIN, Statistics Latvia

Inflation slowing Inflation peaked in May at a 17.9 per cent rate due to unprecedented hikes in regulated prices and commodity prices but started to lose momentum in the summer, partly due to a substantially drop in consumption. In August, consumer prices rose 15.7 per cent yearon-year. Despite this autumn’s 40 per cent hike in natural gas prices, inflation will decrease to 13 per cent by year-end. Absent further energy price and tax hikes in 2009 and because of constrained consumption, it will fall to single digits next spring. We expect inflation to average 16.1 per cent in 2008, 8 per cent in 2009 and 5 per cent in 2010. The latter is nevertheless nearly twice the rate that Latvia would need to show in order to meet the inflation criterion for joining the euro zone, so euro adoption is still far away.

The government is under pressure from the business community and voters in general to soften the impact of the approaching recession and stimulate purchasing power. Since the spring, the government has taken steps to improve Latvia’s competitiveness in 2009. This has included increasing the availability of export guarantees, allowing faster depreciation of assets, exempting investments in new technologies from profit taxes, reducing bureaucracy and speeding up the utilisation of EU funds. The authorities have responded to the demands of commercial banks by broadening liquidity in the financial market and by lowering reserve requirements.

In line with our expectations, the current account deficit has decreased. During the first half of 2008, it was 16.9 per cent of GDP, compared to 25 per cent a year earlier. The main factor was a shrinking foreign trade deficit, due to good export performance and lower imports. In addition, Latvia recorded a more positive service balance. Weak domestic demand will lead to a further decrease in the current account deficit to 10 per cent of GDP in 2009. However, financial and economic challenges in Latvia’s main export markets will blunt further export

13

Lithuania Eastern European Outlook — October 2008

of the global credit crunch, will reduce the appetite for Lithuanian goods. CIS exports remain strong (Russia absorbed 15.1 per cent of Lithuanian exports in January-July), due to lower inflation in Lithuania and strong economic growth in these markets. Increased political risk in Eastern markets has not translated into actions limiting purchases of Lithuanian exports.

Soft landing so far n n n

Growth is gradually slowing down No major easing of inflation Outcome of parliamentary elections uncertain

GDP grew by 5.2 per cent year-on-year in the second quarter of 2008. This was slower than in the first quarter, when GDP grew by 7 per cent. The slowdown will be more apparent in the second half of the year. Our latest forecast of 5.5 per cent GDP growth for 2008 as a whole is still realistic. In 2009 downside pressure will be stronger, given weakening sentiment in domestically oriented sectors such as construction, retail trade and transport. Moreover, sectors relying on exports are also facing uncertainty, since Lithuania’s main export markets are stagnating. We expect the country to avoid a technical recession, but GDP growth will be weak: 2 per cent in 2009 and 1 per cent in 2010. Our forecasts have been cut.

Lithuania: Domestic demand and exports Year-on-year percentage change, constant price 20.0

20.0

17.5

17.5

15.0

15.0

12.5

12.5

10.0

10.0

7.5

7.5

5.0

5.0

2.5

2.5

0.0

0.0 Q1

Q2

Q3

Q4

06

Lithuania: GDP and inflation

Domestic demand

SEB forecast

14.0

10.0 8.0 6.0 4.0 2.0 0.0 -2.0 01

02

GDP (LHS)

03

04

05

06

07

08

09

Q3 07

Q4

Q1

Q2 08

Exports

Lithuania exceeded its tax collection target for the first half of the year, but a gap emerged as early as July. It will widen further by the end of the year as decelerating retail sales limit value-added tax revenue. Moreover, the profitability of enterprises is set to decline and corporate tax inflow might shrink correspondingly. Given the election cycle, public expenditure cuts will be limited in scope. Moreover, recent law on the indexation of minimum wages, pensions and social benefits as well as agreed pay increases in the health and education sectors will sustain pressure on public expenditures. Although the fiscal discipline law prescribes only a 0.5 percent deficit for 2009, we are raising our fiscal deficit forecast to 1.5 per cent of GDP this year and next.

12.0

00

Q2

Sources: Statistics Lithuania, SEB

Year-on-year percentage change 11 10 9 8 7 6 5 4 3 2 1 0

Q1

10

Inflation (RHS) Sources: Statistics Lithuania, Eurostat, SEB

Domestic demand will dampen further in the wake of deteriorating consumer sentiment, tighter lending conditions and an inflation spike due to rising central heating charges. In the second quarter, retail growth slowed markedly, and consumer sentiment worsened sharply in the summer months. January-August 2008 retail sales grew by 10.1 per cent year-on-year, following first quarter growth of 29.4 per cent. The domestic market is cooling due to stagnating real estate and construction sectors (especially the residential segment). This will dampen related activities such as production and sale of construction materials, furniture and domestic appliances. Ober Haus Real Estate research notes that prices of residential properties fell roughly 10 per cent in the first half of 2008. Overall 2008 prices could fall by 15 per cent, and in 2009 by a further 10 percent.

Wage and salary growth coming down Nominal wages and salaries continue to grow fast, although real wage growth is slowing down. During the second quarter of 2008, average gross wage growth remained robust at 22.5 per cent year-on-year. Public sector wages were supported by decisions that took effect from January 1, 2008 – a minimum monthly wage increase, an increase in base earnings, and a lower personal income tax rate. During the same quarter, additional wage increases took effect in the health and education sectors, and further increases are scheduled in the third quarter.

While domestic demand is slowing, exports are still holding up so far. Downside risks are increasing, however. During January-July 2008, exports increased by 33.8 per cent. However, the slowdown in the euro zone economies, as well as the repercussions

Total gross wage and salary growth should slow to 15 per cent during the fourth quarter due to economic deceleration, statistical base effects and higher unemployment. Public sector wage growth in 2009 will be contained due to an expected deterioration in tax

14

Lithuania Eastern European Outlook — October 2008

Looking further ahead, the energy situation in Lithuania and the region will be improved by constructing new nuclear plants in Lithuania, Kaliningrad and Belarus. To lead and finance the nuclear project in Lithuania, the government controversially merged a private electricity distribution company with state-owned distribution and transmission companies, forming the holding company LEO LT. This company and its consortium partners in Poland, Latvia and Estonia are expected to construct the plant by 2018. Decisions on the size of the plant and the choice of technology will be made during the spring of 2009.

collection by the end of the year. Total gross wage growth in 2009 will still reach 13 per cent.

Inflation will remain high During the summer, the inflation rate began a slight retreat. The easing of food and energy prices in global markets should significantly dampen inflation pressures in the second half of the year. However, increases in public transport fares, educational costs and – most importantly – water, gas and central heating will continue to be major inflationary factors. Therefore average annual HICP inflation, will stay double digit this year. We expect average inflation for 2008 to reach 11.5 per cent.

Slower credit growth Credit growth is slowing. This reflects worsening economic sentiment and tighter lending conditions. Increases in interest rates, high inflation and the expectation of continued corrections in the real estate market have also dampened the appetite for new loans.

As GDP growth slows in 2009, inflation should come down to 8 per cent. A sharper decline in inflation will not occur, since excise duties for fuel, alcoholic beverages and tobacco are expected to increase. Electricity price hikes are also possible, pending decisions by utilities regulators. After the closure of Ignalina nuclear power plant, electricity price increases in 2010 will again re-ignite cost-push inflation pressure. We expect electricity price increases of 10-20 per cent in 2009 and a further 80-90 per cent in 2010 after the Ignalina closure. Our 2010 inflation forecast includes direct effects of about 2.5 percentage points, plus indirect effects of another 1-1.5 percentage points.

During the first half of 2008, the loan portfolios of commercial banks increased by 35.6 per cent yearon-year. We are lowering our full-year forecast to 25 per cent and next years’ to 15 per cent.

Coalition government expected Parliamentary elections are scheduled to take place on October 12. Polls indicate that six parties will attract enough votes to win seats in Parliament. The outcome is difficult to predict, as a sizeable number of undecided voters will be attracted by the referendum on the Ignalina nuclear power plant, and their votes could significantly alter the final composition of Parliament. A coalition government will probably have to be formed. Based on the economic programmes of the parties, two possible coalitions may emerge – centreleft and centre-right. A centre-left government would largely continue the policies of the incumbent government, while the centre-right parties have expressed an ambition to tighten budget expenditures, streamline the public sector and promote foreign direct investment.

Energy from Russia The chances of extending Ignalina’s lifespan until 2012 are shrinking, and the plant is expected to stop operations on December 31, 2009 – its closure could shave up to 3 percentage points off GDP growth. Although a consultative referendum on an extension of Ignalina operations will take place in conjunction with the parliamentary elections in October, European Commission President José Manuel Barroso recently reiterated the stance of the Commission by asking Lithuania to comply with the terms of its EU accession treaty. However, the Commission and EU member states are increasingly aware of the situation in the Lithuanian and regional energy market, and additional measures and financial resources to mitigate the energy supply crunch are expected. The economic cool-down in Europe and Russia will also slow the growth of demand for energy. Therefore the chances are increasing that Russia might have sufficient energy resources to satisfy demand in Lithuania. Yet political and climate risks remain. While Lithuania is not expected to be linked up with major energy markets in Scandinavia and Poland until 2015, apart from Russia it can still import electricity from Estonia and Finland via Latvia and from Ukraine via Belarus.

15

Poland Eastern European Outlook — October 2008

real wage growth is still good. Year-on-year pay increases have been in double digits.

Aiming at the euro n n n

Soft landing for the economy Tighter fiscal and monetary policy Zloty will enjoy support

The tight labour market situation and continued good tax collection would seem to indicate an undiminished economic boom. Meanwhile, according to a number of other indicators, the economic temperature is cooling. Confidence indicators have fallen rapidly. The business sector has turned pessimistic while consumer confidence remains at an elevated level. Manufacturing output and retail trade are showing a rapid cooldown. Corporate profits are weakening.

The global economic slowdown is now drawing Poland into a major deceleration. Previous overheating risks are being replaced by concern about a deep slump accompanied by bankruptcies, rising unemployment and weakened central government finances. However, underlying economic strength and the modest scale of the imbalances built up by Poland point towards relatively good economic performance in the next couple of years. We predict that growth will cool from 6.6 per cent in 2007 to 5 per cent this year and 3.8 and 4.5 per cent annually during 2009 and 2010 respectivly.

The slowdown is arriving from the West, channelled primarily via two mechanisms. First, the outlook for exports and foreign direct investments is worsening as demand falls in Western Europe. Second, Polish consumers and investors are being drawn into the prevailing global pessimism. The cyclical slowdown should not be as deep as the one early in this decade, though, since macroeconomic imbalances are smaller today. Adjustments will thus be less painful. Household and company balance sheets, as well as the banking system, are generally healthy. Continued job creation and re-migration will dampen wage pressure, while productivity growth is relatively good. A continued increase in EU-financed projects and investment needs in preparation for the 2012 European football championships (organised together with Ukraine) are other sources of support.

Economic policy will be dominated by the new government target of a transition to the euro by 2011. This timetable seems optimistic considering the political, economic and legal challenges Poland must overcome. More importantly, though, the process will serve as an economic policy anchor, reducing uncertainty and giving substance to Polish financial assets as harsh winds blow in global markets.

Poland: GDP and inflation Year-on-year percentage change 7

7

Zloty benefits from underlying strength

6

6

Exports as a percentage of GDP — just over 30 per cent — are only half as large as in Hungary and the Czech Republic, but there are strong ties between Poland’s manufacturing output and Germany’s IFO index, for example. The manufacturing sector’s symbiotic relationship with Western Europe, which buys ¾ of Polish exports, leads to powerful upturns as well as downturns. When German demand decelerates, Polish production follows. Exports will thus take a beating before imports cool. We expect the current account deficit to continue climbing to 5.8 per cent of GDP during 2009 and then stabilise in 2010.

SEB forecast

5

5

4

4

3

3

2

2

1

1

0

0 01

02

03

GDP (LHS)

04

05

06

07

08

09

10

Inflation (RHS) Sources: Statistics Latvia, SEB

Growth below potential

The European slowdown will dampen investment activity, thereby holding down FDI in Poland, which will cover less than half of the current account deficit compared to around 100 per cent earlier. But the funds available from the EU are increasingly being utilised.

After eight consecutive quarters of GDP growth above 6 per cent, growth cooled somewhat to 5.8 per cent year-on-year during the second quarter. Given weakening demand, initially from abroad, the growth rate will fall below its potential level of around 5 per cent. In recent years, private consumption and investments have become increasingly influential driving forces. Consumption has benefited from rapid job creation, real wage increases and credit expansion (though substantially more moderate than in various other Central and Eastern European countries). During 2008, disposable income gains have been partly offset by inflation that has climbed to nearly 5 per cent, but

The zloty thus faces a less favourable flow situation, but the upward trend in the currency looks unlikely to end. The extreme uncertainty in financial markets that has prevailed so far during the autumn of 2008 is likely to result in continued “flight to safety” will also harm the zloty in the short term. We nevertheless see three main reasons for continue appreciation against the euro in a longer perspective: higher productivity 16

Poland Eastern European Outlook — October 2008

Euro transition in 2011? preparing to realign its monetary policy towards this end. Euro zone membership by the end of 2001 is technically possible, but a more likely date is 2012. The timetable might look something like this:

On September 10, Prime Minister Donald Tusk made the surprising announcement that Poland is aiming for a transition to the euro in 2011. The central bank is October 2008

Official timetable unveiled

Q4 2008

Application for ERM2 membership

Q1 – Q2 2009

Referendum: constitutional amendments

April 2009

ERM2 membership. Fixing of central parity rate

June 7, 2009

EU parliamentary elections, possible date for referendum

2010

Measurement period for budget and

April 2009 – March 2010

Measurement period for inflation and interest rate criteria

Q2 2010

Verification process (European Commission, Central Bank, Parliament)

Q2 – Q3 2010

Approval (ECOFIN). Final exchange rate

Q4 2010

Practical preparations. Euro zone membership technically possible

January 1, 2012

Euro zone membership, EUR transition

public debt criteria

and growth, rising interest rate spreads and financial convergence in the wake of plans to adopt the euro.

remains at 6.0 percent despite falling inflation. Longer term interest rates will, hower, fall.

Representatives of both the government and the National Bank of Poland (NBP) agree that constitutional amendments shifting authority from the central bank to the ECB are needed and should be adopted before ERM2 accession. In today’s parliamentary situation, the 3/5 majority required for such amendments would probably not be achieved. A referendum on the issue is thus likely (with at least a 50 per cent voter turnout required to be valid) and should take place during the spring of 2009.

Tolerance for a strong zloty will increase. Poland’s currency policy will also be tested. Our assessment is that in practice, the zloty will only be allowed to weaken by 2.25 per cent from its central party rate against the euro upon ERM2 accession. It appears likely that the zloty’s ERM2 period may be far more turbulent than that of the Slovakian koruna, in light of a substantially more challenging global economic situation. The main risks to achieving the goal of a euro transition in 2011 (or 2012) is if the attempts to amend the constitution fail and if a deep economic slide erodes public support for the governing parties in the run-up to the coming elections. We believe euro adoption in 2012 is slightly more probable than in 2013.

Economic stabilisation needed ahead The accelerated euro zone plan will require a tighter fiscal policy in order to keep the budget deficit comfortably below 3 per cent of GDP, the Maastricht Treaty ceiling. This will limit the government’s room for stimulating the economy now that growth is slowing. There will also be less room for generous election promises as Poland votes for its president in 2010 and Parliament in 2011. The budget deficit has decreased in recent years of strong GDP growth, and we expect it to remain at about 2.5 per cent of GDP.

Slow progress on the path to reforms The reform-oriented governing coalition led by the Civic Platform party has a weak parliamentary base but has taken the initiative towards joining the euro zone after a cautious first year in power. It remains to be seen whether this will lead to progress in enacting reforms in such areas as the labour market and the health sector as well as continuing with privatisations and dismantling bureaucratic obstacles.

Monetary policy must also shift from the current inflation target of 2.5 per cent ± 1 point to achieve the Maastricht-defined criterion in practice. Formally, the target is likely to be charged to HICP at 2.0 per cent or lower. The NBP has announced that this will occur when euro adoption plans become firmer. In the coming quarters Polish inflation will slow, thanks to falling/stabilising commodity prices, previous interest rate hikes and weakening demand/wages. But given our forecast of significantly lower inflation throughout the EU (and the strict Maastricht inflation criteria), Poland will probably require even tighter fiscal policy. We expect the real interest rate to rise as the key rate

So far, the pace of reform has been slow because the other coalition partner, the Polish Peasants’ Party, is less reform-minded. Prime Minister Donald Tusk is riding on a wave of popularity that he does not wish to jeopardise before the 2010 presidential election. Above all, President Lech Kaczynsky has announced that he will veto most reforms. The coalition lacks the 3/5 support in Parliament required to override presidential vetoes. In light of this, it is reasonable that reform expectations are rather modest.

17

Slovakia Eastern European Outlook — October 2008

ongoing projects suggest that FDI inflows will slow and that their peak has passed.

Sharp slowdown from high levels n n n

Job growth is continuing, and unemployment will decline somewhat further but remain high compared to other EU countries. Productivity growth is gradually slowing as well.

Private consumption still robust Euro adoption feeds inflation Strong public finances

Despite rising inflation, Slovakia met all the criteria for adopting the euro and will join the single currency area on January 1, 2009. By the end of this year, inflation should lose momentum due to favourable base effects, although a rise in minimum wage and cost-driven inflation factors may start to dominate the inflation picture. Euro adoption will trigger slight price increases due to rounding off of prices and other factors. The government is trying to persuade energy companies to moderate price increases. We expect inflation to average 3.5 per cent in 2008 and 3.6 per cent next year and in 2010.

Slovakia has experienced one of the highest levels of economic growth in the Central European region over the past few years. However, growth will be less spectacular during the next couple of years, since international demand will be weak. Inflation is on the rise, and euro zone accession in January 2009 is expected to hamper the decline in inflation. In the first quarter of 2008, the GDP growth rate was 8.7 per cent. This was higher than in the same period of 2007 but much slower than during the preceding quarter (11.5 per cent). In the second quarter, growth slowed further to 7.6 per cent, which was still the highest rate in the EU. Weakening foreign demand means that the contribution of net exports will diminish. However, it will be partly offset by growing consumption. Our GDP growth forecast is 7 per cent in 2008, 3.5 per cent in 2009 and 4.0 per cent in 2010.

The conversion rate has now been set at 30.1260 koruna to the euro, which corresponds to the current central rate within ERM2. The switch to the European Union single currency has created a buzz among shoppers and consumers, since prices must be stated in both koruna and euro terms.

Solid public finances

Slovakia: EU sentiment indicator and GDP 17.5

120

15.0

115

12.5

110

10.0

105

7.5

100

5.0

95

2.5

90

0.0

85

-2.5

The first half 2008 budget deficit was considerably lower than a year earlier. The government approved a public financial deficit target of 2.2 per cent of GDP for 2009, compared to the 2.3 per cent originally expected. Revenue collection indicates that the government will be able to exceed the target of its deficit reduction plan for this year, but the plan to introduce a 13th monthly pension in order to boost social benefits and lower GDP growth will hamper further tightening in 2009. Owing to good budgetary performance, government debt is expected to diminish slightly in the next couple of years.

80 00

01

02

03

04

05

06

07

08

GDP, year-on-year percentage change (LHS) EU sentiment indicator, index (RHS) Sources: European Commission, Statistical Office of Republic of Slovakia

The concerns that accompanied the formation of a coalition between Prime Minister Robert Fico’s SmerSocial Democracy party and two rightist parties have proved largely unfounded. On the contrary, economic success and political skills have contributed to Fico’s continuously rising popularity. His cabinet faces a major challenge in ensuring a smooth euro introduction process. The government has thus pushed through a law that threatens fines and blacklisting for those who take advantage of the currency transition.

During January to June, Slovakia showed an increase in its current account deficit, which will probably widen through the year. While the foreign trade surplus improved slightly, this was unable to offset deteriorating service, income, and current transfer accounts. The biggest shift came on the service account, which went from surplus to deficit, indicating that in this sector, Slovakia is perceived as less attractive than neighbouring countries. During the first five months, foreign direct investment reached a net inflow of EUR 126 million, down from EUR 136 in the year-earlier period. The economy is reaping the fruits of the past investment boom and ongoing projects in the automotive and electrical equipment industries. However, global developments and the completion of

18

The Czech Republic Eastern European Outlook — October 2008

slow the performance of the whole economy. The economy consequently will rely more on foreign trade than on the domestic sphere.

Past the peak n n n

Economy still resilient, slower growth Broad-based weakening Inflation the top challenge

Consumer prices have climbed in the past year due to tax changes as well as rising global commodity and food prices. Inflation peaked at a nine-year high of 7.9 per cent in January 2008. The continued rise in food and energy prices has prevented any big slowdown in inflation. However, owing to a decline in the prices of food and non-alcoholic beverages and transport, yearon-year consumer price growth slowed to 6.2 per cent in August, the lowest rate this year. In the first two quarters of next year, we expect inflation to moderate further. Due to base effects, 2009 inflation will not reflect tax changes implemented in 2007. The increase in regulated prices will slow as well. We forecast average inflation of 6.4 per cent this year, slowing to 3.0 per cent in 2009 and 2.8 per cent in 2010.

The Czech economy is past its cyclical peak and is cooling down. However, the economy remains generally resilient and has not seen any substantial impact from the global financial crisis. GDP growth was previously driven by foreign trade, but its strength will wane during the rest of 2008 and in 2009 owing to the cool-down in most of Europe. Reflecting weaker consumer spending and the stagnating euro zone economies, the Czech economy expanded at its slowest pace in four years: 4.5 percent during the second quarter of 2008, compared to 5.1 per cent in the first quarter. Since both export growth and domestic demand are continuing to slow and this trend will continue next year. The GDP growth forecast for this year is 4.1 per cent. We expect growth to slow further to 2.5 per cent in 2009, and we expect some improvement in 2010.

Further interest rate cuts Early in the summer, the koruna climbed significantly, hitting records. The Czech National Bank cut its key interest rate by 25 basis points to 3.50 per cent in August. The CNB was reacting to the koruna’s exchange rate against the euro, which dipped below CZK 23, making it the first central bank in the region to loosen policy. This was the first rate cut in more than three years and was an attempt to counter the koruna’s record appreciation to try to revive fading economic growth. The slowing economy gives the CNB room for further easing of monetary conditions. It may decide to cut interest rates further this year, but the next move will depend on inflation developments and expectations, as well as other factors. The key rate will bottom out at 2.75 per cent in 2009.

Czech Republic: HICP and repo rate Year-on-year percentage change and per cent 8

4.0

SEB forecast

7 6

3.5

5 4

3.0

HICP (LHS)

3 2

2.5 = yearly average

1 0 -1

2.0

The koruna’s strength is not consistent with slowing domestic growth. The exchange rate trend of the koruna will take its toll on export performance and on investments. Our EUR/CZK forecast for the end of 2009 is 24.2.

Repo rate (RHS)

-2

1.5

03 04 05 06 07 Sources: Eurostat, Reuters Ecowin

08

09

10

During the first half of 2008, exports grew by 5.2 per cent and imports by 4.8 per cent. The trade surplus surpassed last year’s performance but shrank during the second quarter. There will be further deterioration in export volume and subsequently also in the trade and the current account balance, the latter deteriorating to minus 3.5 per cent of GDP in 2009.

Euro still elusive The Czech Republic has not yet fixed an official date for euro adoption, but the business community is pushing the government to do so, in order to maintain the attractiveness of the economy. As for joining the euro zone, low inflation and public sector fiscal discipline will be the most important issues. The proposed budget for 2009 should ensure a public sector deficit of 1.6 per cent of GDP. However, with growth falling and elections coming up in 2010 we expect a moderate fiscal loosening. The government wants to continue to reduce the gap to 1.2 per cent in 2012. Inflation has thus become the main obstacle to euro adoption in the next few years.

On January 1, 2008 the Czech Republic introduced a flat income tax rate of 19 per cent, replacing four progressive rates and leaving most workers with more cash. In the second quarter, however, real wages grew at the slowest pace in almost ten years. Real wage growth is likely to remain sluggish during the rest of this year but will recover next year as inflation falls. Combined with increasing unemployment, it will

19

Hungary Eastern European Outlook — October 2008

and government expenditures were still declining, compared to the first half of 2007. This summer, the agricultural harvest almost doubled from the same period a year ago, contributing significantly to the country’s value-added. Construction earnings also improved in the second quarter of 2008, largely owing to public tenders for motorways.

Slower recovery n n n

Domestic demand is picking up Fiscal loosening from 2009 Sluggish decline in inflation

Hungary is starting to emerge from its economic problems. The ”double deficit” is back to more sustainable levels. GDP growth has recovered after a very slow trend last year. The main growth engine will gradually shift from foreign demand back to domestic demand. In 2008, real GDP growth should reach 1.9 per cent. We foresee 2.2 per cent growth in 2009 and 3.5 per cent in 2010. Inflation is heading downward.

In the near future, domestic demand should recover further, supported both by loosening fiscal and monetary policies. On the other hand, the labour market is recovering slowly and banks are tightening their credit conditions in the face of the global liquidity crunch. There is a risk that the credit crunch may affect Hungary more severely. Meanwhile, noticeable challenges await net exports in the near future, as growth stalls in Hungary’s main export markets (in the euro zone) and competitiveness is eroded by the relatively strong forint and high inflation.

Tax reductions ahead After adopting its belt-tightening policies in September 2006, the government has achieved the desired economic results. Harsh austerity measures helped reduce the budget deficit from 9.2 per cent of GDP in 2006 to a projected 3.8 per cent in 2008. The government is consequently now considering a step in the opposite direction, i.e. providing some fiscal stimulus to the economy. Early in September, Prime Minister Ferenc Gyurscány proposed tax cuts equalling HUF 300 billion (EUR 1.2 billion) in 2009 (1.1 per cent of GDP) and HUF 1.2 trillion by 2012. The package includes cutting the corporate tax rate from 20 to 18 per cent, lowering payroll taxes and making the lower of two personal income rates applicable to higher salaries.

Despite Hungary’s poorer competitiveness and the weak economic growth in Western Europe, in the first half of 2008 external trade moved into surplus from a substantial – and traditional – deficit a year earlier. However, pressure on the current account will rise as exports are squeezed and imports accelerate due to recovering domestic demand. The current account deficit should fall to 6 per cent of GDP in 2008, 5.7 per cent next year and 5.2 per cent in 2010. In August 2008, year-on-year HICP inflation fell to 6.5 per cent, its lowest rate since October 2006, helped by stumbling domestic demand. Inflation is likely to drop further in the second half of this year due to favourable base effects, declining food prices due to the plentiful harvest and the effects of interest rate hikes last spring. However, administratively controlled gas and electricity prices are set to rise in the next few months. As consumption starts recovering, demand-pull pressures may also become a renewed potential source of inflation next year. We are forecasting average HICP inflation of 6.5 per cent in 2008, 4.2 per cent in 2009 and 3.2 per cent in 2010.

If approved, this package would encourage economic growth. On the other hand, it may threaten to push the budget deficit much higher, since Mr Gyurscány has rejected cuts in social expenditures proposed by the liberal Alliance of Free Democrats, which withdrew from his government last spring. The tax reduction proposal sparked new controversy in the political arena. On October 11, a gathering of the ruling Socialist party will decide whether to support the Prime Minister’s proposed early election. According to our base scenario, Gyurscány will remain in office but some adjustments in his current proposals for fiscal policy reforms will be carried out before approval. The next parliamentary election is scheduled for 2010.

Meanwhile, the National Bank of Hungary expects inflation to fall to its 3 per cent target within three years. We thus expect NBH to adopt a dovish stance but to do it slowly and to reduce its key interest rate, currently at 8.5 per cent, to 7.25 per cent by the end of 2009 and 6.5 per cent by the end of 2010.

Comeback for the domestic market

Despite support against other major currencies, due to high interest rate differentials, the forint will be vulnerable due to political turbulence and weak global

After almost stagnating in 2007, this year the Hungarian economy is showing somewhat more robust growth. In the first half of 2008, real GDP rose 1.9 per cent year-on-year, compared to a 0.9 per cent increase in the second half of 2007. The economy continues to be driven mainly by net exports. Household consumption also showed a minor increase in January-June 2008. However, gross capital formation

20

Key economic data Eastern European Outlook — October 2008

CZECH REPUBLIC 2003 GDP, % 3.6 Inflation, HICP, average, % -0.1 Unemployment, ILO, % 7.8 Current account, % of GDP -6.2 Public sector financial balance, % of GDP -6.6 Public sector debt, % of GDP 30.1 EUR/CZK, end of period 32.40 Key rate, eop 2.00 5-year government bond, eop 3.70

2004 4.2 2.6 8.3 -6.0 -3.0 30.4 30.30 2.50 3.40

2005 6.1 1.6 7.9 -2.1 -3.6 29.8 29.00 2.00 3.20

2006 6.4 2.1 7.1 -3.1 -2.7 29.6 27.50 2.50 3.70

2007 6.5 3.0 5.3 -2.5 -1.6 28.7 26.60 3.50 4.00

2008(f) 4.1 6.4 4.7 -2.4 -1.8 28.5 25.50 3.25 3.80

2009(f) 2.5 3.0 5.0 -3.5 -2.3 28.2 24.20 2.75 3.00

2010(f) 3.3 2.8 4.6 -3.5 -2.5 27.8 23.00 3.00 3.40

2004 7.5 3.0 9.7 -12.3 2.3 5.2 15.6 2.4

2005 9.2 4.1 7.9 -10.0 2.3 4.4 15.6 2.6

2006 10.4 4.4 5.9 -15.5 3.8 4.1 15.6 3.9

2007 2008 (f) 2009 (f) 2010 (f) 6.3 -1.5 -2.2 2.0 6.6 10.5 5.0 3.5 4.7 5.5 7.0 6.0 -17.4 -10.0 -8.0 -8.5 2.9 -1.5 -1.0 -0.5 2.7 3.0 3.2 3.5 15.6 15.6 15.6 15.6 7.3 6.7 5.3 4.9

2004 4.8 6.8 6.1 -8.6 -6.5 59.4 245.9 9.50 8.00

2005 4.1 3.5 7.2 -7.5 -7.8 61.6 252.7 6.00 7.10

2006 3.9 4.0 7.5 -7.5 -9.2 65.6 252.3 8.00 7.40

2007 1.3 7.9 7.6 -6.4 -5.4 66.0 252.0 7.50 7.40

ESTONIA 2003 GDP, % 7.1 Inflation, HICP, average, % 1.4 Unemployment, % 10.0 Current account, % of GDP -11.3 Public sector financial balance, % of GDP 2.0 Public sector debt, % of GDP 5.7 EUR/EEK, end of period 15.6 3-month interest rate, eop 2.6

HUNGARY 2003 GDP, % 4.2 Inflation, HICP, average, % 4.7 Unemployment, % 5.9 Current account, % of GDP -7.9 Public sector financial balance, % of GDP -7.2 Public sector debt, % of GDP 58.0 EUR/HUF, end of period 262.2 Key rate, eop 12.50 5-year government bond, eop 9.30

(f) = forecast

21

2008(f) 1.9 6.5 7.7 -6.0 -3.8 63.0 265.0 8.50 8.80

2009(f) 2.2 4.2 7.2 -5.7 -3.8 61.0 240.0 7.25 6.80

2010(f) 3.5 3.2 6.9 -5.2 -3.5 60.0 225.0 6.50 6.50

Key economic data Eastern European Outlook — October 2008

LATVIA 2003 GDP, % 7.2 Inflation, HICP, average, % 2.9 Unemployment, % 10.6 Current account, % of GDP -8.2 Public sector financial balance, % of GDP -1.6 Public sector debt, % of GDP 14.4 EUR/LVL, end of period 0.67 Key rate, eop 3.00 5-year government bond, eop 4.60

2004 8.7 6.2 10.4 -12.8 -1.0 14.5 0.70 3.50 4.00

2005 10.6 6.9 8.7 -12.5 -0.4 12.0 0.70 4.00 3.20

2006 12.2 6.6 6.8 -22.5 -0.2 10.0 0.70 5.00 4.90

2007 10.3 10.1 6.0 -23.8 0.0 9.3 0.70 6.50 7.50

2008(f) -0.5 16.1 7.0 -13.5 -1.5 9.0 0.70 6.00 7.50

2009(f) -2.0 8.0 9.0 -10.0 -3.0 9.3 0.71 5.50 7.00

2010(f) 2.0 5.0 8.5 -8.5 0.0 9.5 0.70 5.50 6.50

2004 7.4 1.2 11.4 -7.7 -1.5 19.4 3.45 2.60 3.00

2005 7.8 2.7 8.3 -7.1 -0.5 18.4 3.45 2.50 3.10

2006 7.8 3.8 5.6 -10.6 -0.4 18.0 3.45 3.80 3.90

2007 8.9 5.8 4.3 -14.6 -1.2 17.0 3.45 6.70 4.50

2008(f) 5.5 11.5 5.0 -12.0 -1.5 14.5 3.45 6.00 6.30

2009(f) 2.0 8.0 6.5 -10.0 -1.5 16.0 3.45 5.80 6.00

2010(f) 1.0 11.0 7.0 -11.0 -2.0 17.0 3.45 5.60 5.80

2004 5.3 3.6 19.0 -4.2 -5.7 45.7 4.08 6.50 6.20

2005 3.6 2.2 17.7 -1.7 -4.3 47.1 3.86 4.50 5.00

2006 6.2 1.3 13.8 -2.3 -3.8 47.6 3.83 4.00 4.98

2007 6.6 2.6 11.7 -3.8 -2.0 45.2 3.60 5.00 6.13

2008(f) 5.0 4.3 10.0 -5.2 -2.5 43.0 3.60 6.00 5.80

2009(f) 3.8 3.3 9.5 -5.8 -2.8 42.0 3.10 6.00 4.70

2010(f) 4.5 2.3 9.0 -5.5 -2.5 41.0 2.90 5.50 4.20

LITHUANIA 2003 GDP, % 10.2 Inflation, HICP, average, % -1.1 Unemployment, % 12.4 Current account, % of GDP -6.8 Public sector financial balance, % of GDP -1.3 Public sector debt, % of GDP 21.1 EUR/LTL, end of period 3.45 3-month interest rate, eop 2.70 5-year government bond, eop 3.60

POLAND 2003 GDP, % 3.8 Inflation, HICP, average, % 0.7 Unemployment, % 19.6 Current account, % of GDP -2.1 Public sector financial balance, % of GDP -6.3 Public sector debt, % of GDP 47.1 EUR/PLN, end of period 4.71 Key rate, eop 5.25 5-year government bond, eop 6.70

(f) = forecast

22

Key economic data Eastern European Outlook — October 2008

RUSSIA 2003 GDP, % 7.3 Inflation, average % 13.7 Unemployment, % 8.6 Current account, % of GDP 8.2 Public sector financial balance, % of GDP 1.4 Public sector debt, % of GDP 29.6 EUR/RUB, end of period 29.50 3-month interest rate, eop 6.90

2004 7.2 10.8 8.2 9.9 4.9 22.3 27.70 6.40

2005 6.4 12.7 7.6 11.0 7.7 14.8 28.70 6.50

2006 7.4 9.7 7.2 9.8 8.4 10.4 26.30 5.80

2007 8.1 9.0 6.1 6.1 6.1 8.6 24.50 6.60

2008(f) 7.0 13.8 5.7 7.5 6.4 7.00 26.00 9.00

2009(f) 5.6 11.2 5.4 2.0 2.0 6.5 26.00 7.75

2010(f) 5.5 8.0 5.4 -1.0 1.2 6.5 26.60 7.00

2004 5.4 7.5 18.2 -7.8 -3.0 41.6 38.70 4.00 4.00

2005 6.0 2.8 16.3 -8.4 -2.9 34.5 37.80 3.00 3.20

2006 8.3 4.3 13.4 -7.0 -3.4 30.8 34.60 4.75 4.20

2007 10.4 1.9 11.1 -5.3 -2.2 29.4 33.60 4.25 4.40

2008(f) 7.0 3.5 10.4 -4.0 -2.1 28.5 30.13 4.00 4.50

2009(f) 3.5 3.6 10.00 -5.0 -2.7 28.0 30.13 3.00 3.50

2010(f) 4.0 3.6 9.3 -5.0 -2.7 27.3 30.13 3.00 3.70

2004 12.1 9.0 8.6 10.6 -3.2 19.6 5.31 9.00 28.00

2005 2.6 13.5 7.2 2.9 -1.8 14.9 5.05 9.50 15.30

2006 7.0 9.1 6.8 -1.5 -0.7 12.4 5.05 8.50 12.80

2007 2008 (f) 2009 (f) 7.3 6.3 3.5 12.8 25.8 16.0 6.4 5.7 6.2 -3.5 -7.5 -10.3 -0.9 -1.5 -3.0 10.1 8.5 12.0 5.05 6.00 6.50 8.00 12.00 10.50 11.40 15.80 14.00

2010(f) 4.4 10.0 6.5 -8.5 -4.0 14.0 6.50 9.50 13.00

SLOVAKIA 2003 GDP, % 4.2 Inflation, HICP, average % 8.4 Unemployment, % 17.6 Current account, % of GDP -5.9 Public sector financial balance, % of GDP -3.7 Public sector debt, % of GDP 42.7 EUR/SKK, end of period 41.10 Kay rate, eop 6.00 5-year government bond, eop 5.20

UKRAINE 2003 GDP, % 9.6 Inflation, average, % 5.2 Unemployment, % 9.1 Current account, % of GDP 5.8 Public sector financial balance, % of GDP -0.2 Public sector debt, % of GDP 24.7 USD/UAH, end of period 5.33 Key rate, eop 7.00 3-month interest rate, eop 23.50

(f) = forecast

23

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