Seb: Eastern European Outlook March 2007

ECONOMIC RESEARCH

•

ENGLISH EDITION

Eastern European Outlook Theme: Overheated in the Baltics

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MARCH 2007

SEB Economic Research Eastern European Outlook - March 2007

Eastern European Outlook is produced twice a year. This report was published on March 21, 2007. It was written by Mikael Johansson (Chief Editor), Bo Enegren, Alge Budryte, Gitanas Nauseda, Hardo Pajula, Vilija Tauraite and Andris Vilks. Klas Eklund, Chief Economist

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Håkan Frisén, Head of Economic Research

8067

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Bo Enegren, Economist

8594

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Ann Enshagen Lavebrink, Research Assistant

8077

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Mikael Johansson, Economist

8093

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Tomas Lindström, Economist

8297

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Alge Budryte, Economist SEB Vilnius Bankas

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SEB, Economic Research, K A3, SE-106 40 STOCKHOLM

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Gitanas Nauseda, Chief Economist SEB Vilnius Bankas

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Hardo Pajula, Chief Economist SEB Eesti Ühispank

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Vilija Tauraite, Economist SEB Vilnius Bankas

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Andris Vilks, Chief Economist SEB Latvijas Unibanka

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2

Summary Eastern European Outlook — March 2007

Central and Eastern Europe will remain economically strong in 2007-2008. Latvia, Estonia and Slovakia will grow the fastest. Growth in the region will be cooled off to some extent by higher interest rates, somewhat lower international demand and increasing supply side restrictions. Rapid pay hikes that stimulate private consumption are a driving force throughout these countries. EU members in the region also receive sizeable sums from the EU structural funds, which will help ensure continued strong investments, especially in Poland. Meanwhile the Baltic countries and Central Europe will be plagued by continued large internal and/or external imbalances, which pose risks of economic and financial instability down the road. No vigorous action in the form of fiscal austerity programmes is on the horizon yet. One exception is Hungary, whose imbalances have been the most accentuated and where budget tightening will continue at the price of a major growth slump and, in the short term, high inflation. Latvia’s austerity package, which was recently unveiled, is not sufficient to bring down the country’s high inflation and ballooning current account deficit more than marginally. The imbalances will affect the euro adoption timetable. In Central Europe, budget deficit are admittedly shrinking. But in 2008, the deficits in Poland, Hungary and the Czech Republic will still be above the threshold to qualify for euro adoption, 3 per cent of GDP. Slovakia may adopt the euro in 2009, but it will take several more years for the other EU countries in the region — including the Baltics, where budgets are balanced but inflation is too high to join the euro zone. The theme article in this issue deals with overheating in the Baltics. Latvia and Estonia continue to exhibit clear signs of overheating after several years of excessively fast, domestically driven growth. Our main scenario is a soft landing for these economies. But this presupposes a continued slowing of high credit growth. Commercial banks must be more restrictive about lending. Fiscal tightening may also be required in Estonia to avoid a hard landing that might include currency devaluations. Russia’s economy will continue growing at a healthy pace, fuelled by domestic demand. Expansive fiscal policy ahead of the Duma and presidential elections, combined with high commodity prices, will support such growth. Investments have taken off, but the level remains relatively low from the perspective of long-term growth requirements. Russia faces a variety of challenges due to capacity constraints in the energy sector, real appreciation of the rouble, unfavourable demographics and increased labour shortages. Meanwhile Russia’s expected World Trade Organisation membership in 2008 will pave the way for better growth. In the past year, Ukraine has returned to its growth track. GDP is increasing relatively fast. Driving forces include domestic and partly credit-driven demand, as well as favourable global commodity markets. In recent months, political worries have re-emerged. Speculation about a currency devaluation may surface once again.

3

The international economy Eastern European Outlook — March 2007

In Europe, the Nordic countries will stand out due to continued high growth, with mounting risks of overheating in Denmark and Norway. Sweden and Finland will grow by an average of more than 3 per cent annually, accompanied by a mild upturn in inflation during 2008.

Robust growth „ „ „

Mild deceleration in the US Europe and Asia resisting US slowdown well Weaker dollar

The euro zone will continue to enjoy good growth, combined with subdued inflation; GDP will increase by 2½ per cent annually and inflation will be in line with the European Central Bank’s target of just below 2 per cent. The German economy woke up vigorously last year, and both business and household sentiment indicators point towards a continued favourable trend. The labour market will keep on improving throughout the euro zone. Even in Germany, households are expected to be more optimistic — or less pessimistic — about opening up their wallets, while the capital spending upturn will continue. The driving forces of growth will shift successively from exports to domestic demand. Fiscal policy will tighten in many countries, especially in Germany. Combined with good growth, this will cause government budget deficits to shrink.

Global economic growth will remain brisk in the next couple of years, even though US growth has downshifted to moderate speed. Dynamic domestic demand in Western Europe and rapid growth in Asia will fuel expansion. The world economy will also continue to be driven by powerful long-term supply side forces. Tough competition and rapid productivity increases will slow inflation. Energy prices will probably level off as well. This means that both central bank tightening and a market-governed upturn in long-term bond yields will be modest. World economic expansion can thus remain well above its 3½-4 per cent trend level. GDP growth Year-on-year percentage change

United States Japan China Euro zone Nordic countries OECD World

2005

2006

2007

2008

3.2 1.9 9.9 1.5 2.9 2.6 4.9

3.3 2.2 10.5 2.8 3.9 3.2 5.2

2.4 2.0 10.0 2.5 3.2 2.7 4.7

2.7 2.0 9.5 2.3 2.5 2.7 4.7

European interest rates upward The Fed has stopped raising its key interest rate, while central banks in Western Europe will continue to hike theirs. This will occur largely for preventive purposes. Long-term inflation risks stemming from tighter labour markets and rapid lending growth will weigh heavier than today’s low inflation. Several central banks, among them the Bank of England and the Bank of Japan, have also explicitly warned against excessive risk-taking in financial markets. The BoE will raise its key rate a notch this spring, while the ECB will hike its refi rate by a total of 50 basis points during the next six months to 4.25 per cent.

Sources: OECD, SEB

The risk of a deep US downturn has diminished in the past six months. The response of households to falling home prices, in the form of increased saving and lower consumption, appears to be mild. Furthermore, it will take a bit more time before the labour market begins to weaken. Our main thesis is still that the US will undergo a soft landing after a lengthy period of relatively high growth, including some worrisome inflationary impulses last year via the tight labour market. During the fourth quarter of 2006, the economy grew at an annualised rate of just above 2 per cent. Earlier interest rate upturns, continued to cool the construction and real estate markets. In addition, the business sector began to draw down inventories, a process expected to persist for a couple of quarters and to help keep GDP growth down. Meanwhile there are various expansionary forces. Companies are well-consolidated, which promises a continued capital spending upturn. The dollar is expected to weaken, which will benefit exports. And late this year, we anticipate that the Fed will carry out the first of two interest rate cuts. Overall GDP growth will be around 2½ per cent annually in 2007-2008. This is somewhat below the potential level of around 3 per cent.

Bond yields will climb a bit higher, after sinking at the time of the February stock market slide. They will rise somewhat more in Western Europe than in the US, due to economic strength and higher key rates. Interest rate spreads have been an important force in the foreign exchange market in recent years and will continue to play a key role. The dollar will weaken as US-European rate spreads shrink. At the end of 2007, a euro will be worth USD 1.35. The dollar will stop falling during 2008 as the American economy begins to accelerate again. We assume that oil prices (Brent) will be at USD 62/ barrel during the next couple of years.

4

Russia Eastern European Outlook — March 2007

capable of boosting the growth potential of the economy. The challenge is still to elevate the level of private investments, and there are a number of lingering question marks concerning the general investment climate. Corruption, unclear rules of the game and ever-increasing public sector intervention in the business sector must be weighed against rapid growth, strong federal finances and low external indebtedness.

Macroeconomic strength, structural question marks „ „

„

Continued consumption boom Large but shrinking budget and current account surpluses No change of course after presidential election

Last year the surplus in the federal government budget amounted to 7 per cent of GDP, largely unchanged from the year before, despite major increases in expenditures. The explanation is continued large oilrelated revenue. Given lower average oil prices and continued increases in expenditures, the budget surplus will shrink this year to around 4 per cent of GDP. The current account surplus has also culminated, but during the next two years we expect continued sizeable surpluses.

The Russian economy continues to grow at a healthy pace. In 2006, GDP rose by 6.7 per cent, or just above the average for the past five years. Growth will cool only moderately in the next couple of years to 6.5 per cent in 2007 and 6.0 per cent in 2008. Growth is driven, above all, by robust private consumption but investments — including foreign direct investments — have recently gained momentum. Exports continue to increase at a slow pace, mainly due to capacity constraints and insufficient investments in the oil and gas sector. The net contribution from foreign trade thus remains sharply negative, since import volume is increasing several times more than export volume due to strong domestic demand, eagerness to import and weakened competitiveness in the wake of real-term rouble appreciation. Yet foreign trade still provides large but diminishing surpluses, thanks to a favourable price trend for Russia’s commodities-heavy exports.

6

15

4

10

2

5

Inflation has trended downward in the past six years. Last year it fell below 10 per cent. The Bank of Russia’s primary means of slowing inflation is to allow a certain nominal appreciation of the rouble. Last year this amounted to nearly 4 per cent in relation to a basket consisting of 60 per cent US dollars and 40 per cent euros. In February, the composition of the basket was changed to 45 per cent euros and 55 per cent dollars. We expect the rouble to strengthen somewhat further in the next couple of years, which will help keep inflationary pressure down. Among offsetting factors will be continued fiscal expansiveness, gradually higher energy prices and a tighter labour market. Overall, we foresee a continued downtrend in inflation, but at a somewhat slower pace. Last summer’s decision to make the rouble convertible will eventually open the way to a more developed capital market. This in turn will make it easier for the central bank to pursue a more traditional interest rate-determined monetary policy. Central bank representatives have also hinted that they may switch to a clearer inflation target within five years.

0

Challenges further ahead

Russia: GDP and inflation Year-on-year percentage change 25

10

GDP (LHS) Inflation (RHS)

SEB forecast

8

0

2000

2001

2002

2003

2004

2005

2006

2007

2008

20

While short-term growth prospects look bright, not least because the large public financial surpluses are now increasingly being spent, it will be more difficult to sustain high growth in the medium term. During the first half of the present decade, the Russian economy benefited from a number of factors that are now fading away.

Sources: Federal State Statistics Service, SEB

Due to continued rapid real wage increases, a stronger labour market and fiscal stimuli, consumption will remain the most important growth force over the next two years. The appetite of households for credits has also risen sharply, including a rapid increase in residential mortgage lending. This is fuelling consumption even more. The investment outlook appears more uncertain, but public spending on infrastructure and expansion in domestically oriented sectors are signs that investments will also increase at a healthy pace during the next couple of years. The level of investments will remain relatively low, however, and it is uncertain to what extent public investments will be

„

5

The sharp weakening of the rouble after the 1998 financial crisis gave Russian industry a substantial competitive advantage. Since then, the real effective exchange rate has been climbing and has even passed its pre-1998 level. Although it is unclear whether the rouble is over-valued today, Russia’s competitiveness has undeniably weakened, as has

Russia Eastern European Outlook — March 2007

„

60 50

20 10 01

180 170

160

160

150

150

140

140

130

130

120

120

110

110

100

100

90

90

80 98

99

00

01

02

03

04

05

03

04

05

06

Oil price, Ural, (LHS)

Sources: Federal State Statistics service, Reuters EcoWin

The government’s policy for stimulating investments includes the launching of a federal investment fund, as well as the establishment of economic zones. The investment fund, created in 2006, is aimed at financing collaboration between the public sector and private market players in order to stimulate innovation and diversification in the economy. The money available to the fund is relatively modest, about 0.3 per cent of GDP in 2007. The importance of the fund will instead depend on whether it is able to serve as a model for how to select and implement investment projects in an efficient, transparent way, rather than on the actual size of its investments. The new economic zones are intended to serve as innovation centres and will enjoy special tax advantages. Worth mentioning in addition to these initiatives for raising the level of investments are Russia’s high-priority “national projects”, including housing construction investments. While the Russian Federation government is trying to encourage investments in this way, its own burgeoning involvement in the energy sector in particular is hampering investments. High taxation in the energy sector has probably also helped inhibit investment activity. Discussions are under way on changes in tax rules to increase incentives for exploiting new oil and gas resources. For some time there have also been plans to enact a law that will define what sectors are regarded as strategic, which in itself would dispel some of the uncertainties related to investment decisions. Possible Russian WTO membership also implies making the rule system governing foreign investments clearer (see box). Regardless of the government’s intentions, extensive bureaucracy and corruption remain serious obstacles to a more favourable Russian investment climate.

80 97

02

Oil production (RHS)

Index 170

40 30

Russia: Real effective exchange rate 180

14 13 12 11 10 9 8 7 6 5 4 3 2 1 0

Per cent

Russia: Production and oil price 70

USD/Barrel

„

of value-added, such as steel and chemicals, are and will remain a small part of the economy during the foreseeable future.

also been evident from sharply negative contributions from foreign trade since 2004. Due to the phase-out of highly subsidised energy prices, another competitive advantage will gradually fade. In the first post-crisis years, production rose sharply without any major investments because capacity utilisation was initially so low. This “easy” way of boosting production is hardly available any longer, since a large proportion of capacity has been mobilised. Labour market resources are also becoming scarcer. Unemployment has fallen significantly, while the working-age population is now beginning to fall. During the early years of the decade, growth was largely driven by rising production and exports in the oil and commodities industry. When production decelerated in 2004, among other things due to insufficient investments, the commodities sector continued to fuel growth, thanks to sharply rising prices for oil and other commodities. Large oil income will continue to fuel economic growth in the short term, especially as fiscal policy becomes more expansive, but given our forecast of an oil price stabilisation at current levels, the stimulative effects will slowly diminish.

06

Source: J.P. Morgan

Speeding up investments and bringing about a diversification of the economy are regarded by the political leadership as high-priority economic policy tasks. To date, there has also been a diversification of the economy in the sense that resources have been transferred from the commodities sector to such domestic sectors as the distributive trades and construction. The Russian labour force seems to be relatively mobile between sectors, whereas geographic mobility is substantially more sluggish. This is also leading to major labour shortages in some expansive areas, for example the St. Petersburg region. Looking at the composition of exports, however, we cannot say there has been any diversification away from dependence on commodities. On the other hand, the dependence on commodities does not appear to have greatly increased either. Russian industry outside of the energy sector and other industries with a low level

While Russia is showing structural weaknesses, its macroeconomic development has been impressive in recent years. Both the budget and the current account have generated huge surpluses, which have enabled 6

Russia Eastern European Outlook — March 2007

small liberal parties. The room for surprises has also diminished, among other things due to certain constitutional changes, such as raising the threshold for getting into the Duma from 5 to 7 per cent. Meanwhile independent candidates may no longer be elected.

Russia to pay off major portions of its foreign debt, sharply increase its foreign exchange reserve and allocate funds to the national oil Stabilisation Fund, which has grown in only a few years from nothing to the equivalent of 10 per cent of GDP. Although fiscal policy has become substantially more expansive in the past two years, there has still been significant resistance to spending Russia’s large oil income. This means that the country is well prepared for any downturn in oil prices. Oil prices would also have to fall below USD 40/barrel (Ural) for the budget to show a deficit, i.e. far lower than our own assumptions of an average oil price of around USD 59/barrel.

Instead the excitement about President Putin’s successor is growing. There is still speculation that Putin might defy the constitution and remain in office for a third term, but time seems to be running out for such a solution. Most likely, one of the main candidates — Dmitry Medvedev, deputy prime minister and chairman of Gazprom, or Sergei Ivanov, defence minister and recently also promoted to deputy prime minister — will succeed Putin. Of the two candidates, Medvedev currently enjoys greater popular support. He is also generally regarded as a more liberal-minded candidate than Ivanov, which on the other hand may put him at a disadvantage among more hard-line circles in the Kremlin.

The Stabilisation Fund now serves partly as a buffer against oil price fluctuations and partly as a way of countering upward pressure on the rouble by investing oil income in foreign financial assets. According to OECD estimates, about 3/5 of increased oil revenue in 2004-2005 was neutralised by allocations to the Stabilisation Fund and advance payments of loan principal. Oil revenue in excess of USD 27/barrel (Ural) goes directly into the oil fund or towards paying off federal government debt.

The blessings of Putin are generally regarded as indispensable to the successful candidate. This probably also means there will be little political change after a new president takes over, at least in the short term. We expect the direction of government policies to remain largely in place. It is also entirely conceivable that Putin will launch a relatively unknown candidate for the presidency. As for Putin’s own future role, it is hardly likely that at age 55 he will be content with the role of pensioner. Instead, he is likely to continue to play a key role in Russian public life, for example via a top position at Gazprom.

Russia elects the lower house of the federal Parliament (or Duma) in December 2007 and a new president in March 2008. There is no doubt as to which election is attracting greater interest. During Vladimir Putin’s years as president, more and more power has been concentrated in the Kremlin at the expense of the Duma. The Duma election is also highly predictable, since there are hardly any clear anti-Kremlin opposition forces except for the Communist Party and the Russia on its way into the WTO One of the last obstacles to Russian membership of the World Trade Organisation was removed in November 2006 when a bilateral protocol was signed with the US. In January the final remaining bilateral negotiations with El Salvador and Costa Rica were concluded. What remains is multilateral negotiations in which the final terms of membership will be decided. These negotiations will proceed this spring and at best be completed during the summer. In that case, a WTO agreement could go into effect in January 2008.

percentage points to 11 per cent on average. For a number of industrial commodities, the reduction will be much larger than this. However, this will occur gradually over several years. The direct effects of these cuts will probably be relatively small. Russian consumers may benefit from cheaper import prices, while Russian manufacturers will have cheaper input goods and can probably improve their productivity. Some companies in now-protected sectors can also be expected to be forced out of business. Since Russia’s most important export goods, oil and gas, lie outside WTO jurisdiction, exports will not be affected so much. However, for some sectors such as steel and chemicals, membership would mean additional export potential.

However, there is a risk that obstacles will emerge along the way. One might be Russian plans to raise its export duties on timber. The purpose from Russia’s perspective is to increase the low degree of value-added in its forest product industry. The first hike is scheduled for July 2007, followed by a number of additional hikes. This would adversely affect the Nordic forest product industry, especially in Finland, where timber supplies would become substantially more expensive.

The real potential of future WTO membership, however, is that the service sector will open up to foreign investments. The removal of various formal and informal barriers might lead to sizeable improvements in the functioning of the Russian economy, including generally increased liberalisation and greater integration into the global economy.

If it joins the WTO, Russia undertakes to lower its tariffs on industrial and agricultural products by 3

7

Ukraine Eastern European Outlook — March 2007

2006, positive impulses came from an improved situation in global metal markets and the recovery of Ukrainian exports. Industrial production increased by 6.2 per cent last year, twice as much as in 2005.

Growth accelerating despite political turmoil „ „ „

GDP growth gaining speed Inflation still high Political situation remains complicated

Ukraine: Domestic credit UAH billion

Political developments in Ukraine remain hard to predict. This has repercussions on foreign relations as well as the economic and social climate. Early this year, the Law on the Cabinet of Ministers surfaced as the most important political issue. Unfortunately, the law reinforced the conflict between the President on one hand, and the Prime Minister and Parliament on the other. Despite two vetoes from President Viktor Yushchenko, the law was signed by the Speaker of the Parliament, thus formally entering into force.

250

250

225

225

200

200

175

175

150

150

125

125

100

100

75

75

50

50

25

25 00

One more challenge for the President was the dismissal of Foreign Minister Borys Tarasyuk. In December 2006 Tarasyuk, nominated to his office by the President, was dismissed by Parliament. The President overruled this removal, but the Cabinet of Ministers ignored Yushchenko’s objection. There is some consensus in the social and political elite regarding Ukraine’s intention to join the European Union. However, President Yushchenko and Prime Minister Viktor Yanukovich have different opinions about tactics, which may become an additional source of tension in the future.

01

02

03

04

05

06 Source: IMF

In 2007, the economic situation will change only marginally. Domestic consumption and investment will be key drivers of GDP growth. The prospects for metal exports are uncertain in 2007-2008, given the likelihood of some deceleration in global growth. The International Iron and Steel Institute estimates that global consumption of finished steel products expanded by more than 7 per cent in 2006 but will grow by only 5.8 per cent in 2007. According to analysts polled by Bloomberg, the price of steel will drop by 23 per cent in 2007 and 5 per cent in 2008. The diversification of Ukrainian exports by product groups and regions is still low, making the country sensitive to external shocks, particularly in commodities markets.

Recently the opposition provoked a parliamentary crisis. The Yulia Timoshenko Bloc and Our Ukraine factions declared a boycott of sessions of Parliament. They were referring to a ultimatum signed by Timoshenko and Our Ukraine faction leader Vyacheslav Kirilenko and handed over to the ruling “anticrisis coalition”. Among other requirements the Timoshenko Bloc and Our Ukraine maintain that constitutional reform has led the country into constitutional crisis and are demanding that a commission should be formed to amend the country’s basic law. Prime Minister Yanukovich is in a complicated situation. Any decision that the prime minister refers to the Parliament can be blocked by President Yushchenko at the demand of the Timoshenko Bloc and Our Ukraine.

Ukraine: GDP and inflation Year-on-year percentage change 30

14

GDP (LHS) Inflation (RHS)

12

SEB forecast

10

25 20 15

8 10 6

5

4

Returning to impressive growth Meanwhile, the economy is back on a fast growth track. According to preliminary estimates, real GDP increased by 7.1 per cent in 2006 and at a 9.3 per cent year-on-year pace in January 2007, mainly driven by domestic demand. Final household consumption grew by almost 20 per cent, fuelled by an impressive rise in income and a lending boom. Gross fixed capital formation expanded slightly less but also contributed strongly to economic growth. In the second half of

2

0

2000

2001

2002

2003

2004

2005

2006

2007

2008

-5

Sources: State Statistics Committee of Ukraine, SEB

Ukraine and the EU have signed a new agreement on bilateral steel trade in order to regulate this issue before Ukraine joins the World Trade Organisation. The agreement gives Ukraine a 1.32 m tonne quota on steel exports to the EU market, about 20 per cent

8

Ukraine Eastern European Outlook — March 2007

excessive wage increases, the authorities might use it as a short-term tool to correct external imbalances. Speculative pressure on the national currency might be triggered not only by economic factors, but also by further political conflicts between President Yushchenko and Prime Minister Yanukovich. Due to increasing tensions at the top of its political pyramid and insufficient coordination of foreign policy, Ukraine is sending mixed signals about its strategic goals to the international community.

above the quota for last year. The quota will be abolished immediately after Ukraine becomes a WTO member, completely opening access to EU customers. The European Commission also added milk and eggs to the list of products Ukraine can freely export to the EU single market. Due to the slow pace of preparations, it is not likely that Ukraine will join the WTO during 2007. On the other hand, the Ukrainian government intends to protect domestic producers from external competition. The list of products subject to import licences in 2007 was expanded as compared to 2006. Although the official reason for this decision is the need to strengthen controls on food quality, in fact government seeks to impose additional restrictions on imports as a way to shrink Ukraine’s trade deficit.

Inflation still high The government did not succeed in reducing Ukraine’s annual CPI growth to single digits in 2006. However, inflation decelerated to 10.9 per cent yearon-year in January 2007, partly due to lower inflation on food products. We no longer believe that average CPI growth will return to 7-8 per cent this year because of lower inflationary expectations. There will be further rises in regulated prices, due to an increase in the price of natural gas imports in January 2007. A slowdown in nominal income growth is hardly possible, since wages in certain economic sectors are very low and indexation schemes are becoming more and more popular.

Ukraine: Trade balance USD billion 2.0

2.0

1.5

1.5

1.0

1.0

0.5

0.5

0.0

0.0

-0.5

-0.5

-1.0

-1.0

-1.5

-1.5

-2.0

The central government’s fiscal deficit was 0.9 per cent of GDP in 2006 and will be about the same in 2007, reflecting positive trends in the economy and tax administration. The deficit will be mainly financed by privatisation proceeds, since the government envisages offering some strategic companies for sale. In January 2007, Parliament passed a law allowing the privatisation of the telecommunication giant Ukrtelecom, the electrical equipment manufacturer Electrotyazhmash and the chemical company Odessa Portside Plant.

-2.0 00

01

02

03

04

05

06

Source: National Bank of Ukraine

Thus far, there are no intense discussions about devaluing the hryvnia, but this issue will linger as long as the competitiveness of Ukrainian goods is deteriorating due to high inflation. Devaluation rumours may revive in the near future if the government fails to curb inflation and reduce the country’s current account deficit. Also, both real and nominal wages are increasing faster than labour productivity, thus pushing up unit labour costs and harming competitiveness. In 2006, real wages rose 18.4 per cent, repeating the scenario of the previous year. However, the average monthly wage was UAH 1,041.4 or EUR 160, an extremely low level even by Eastern European standards. Wages in the public sector grew fastest, while industry lagged behind with “only” 15 per cent growth in 2006.

Liberalisation of the energy market In January the government introduced several changes in the gas market. Firstly, it is allowing private gas producers to sell extracted gas by auction. Secondly, the government has amended its regulation on payment procedures. Industrial consumers are now allowed to sign gas supply agreements with gas traders (Naftogas Ukrainy and UkrGasEnergo) at prices that include transport and distribution intermediaries. Such a decision will enable gas buyers to establish direct contacts with gas suppliers, thus improving payment discipline.

According to The Economist’s Big Mac index, the exchange rate of the hryvnia is 47 per cent below its purchasing power parity. However, this is not the best indicator of fair valuation. Ukraine has faced real appreciation in its national currency since a de facto fixed UAH/USD exchange rate regime was introduced in 2001 and CPI growth has exceeded the level of inflation in the country of its trading partners. Although devaluation would not solve the problem of

9

Estonia Eastern European Outlook — March 2007

less exposed competitors might perceive the retrenchment of the market leaders as an opportunity to be seized. Should this happen, the aforementioned miracle will be given yet another boost at a time when the Baltic countries are already making headlines in the international financial press. Ultimately the credit cycle will come to a halt, and expectations of residents that were formed at the peak will have to be reconsidered. To the extent that permanent income estimates will be scaled downward, there will be adjustments in saving behaviour, with a negative impact on domestic demand. In view of this scenario, we are sticking to our earlier growth forecasts of 8 per cent for 2007 and 7 per cent for 2008.

Mistrusted miracle „

„ „

Postponed euro adoption leads to a reassessment of risks Real wages increase at record pace Mounting external imbalances call for an adjustment in domestic saving behaviour

Estonia posted a record growth figure of 11.4 per cent for 2006. This preliminary estimate compares favourably with the previous peak of 11.1 per cent achieved in 1997 and is almost twice as high as the average growth rate of the last 12 years. However, beneath this bravura performance simmers a less appetising stew of mounting capacity constraints, increasing labour costs and accumulating external imbalances. Indeed, we would suggest an assessment that while backward-looking indicators – such as economic growth – may continue to tell a happy story for a few quarters to come, the underlying tenor may already have started to change as residents and nonresidents work gradually through the implications of the uncertainty surrounding euro accession.

Labour market grows white-hot It is nice to be a job seeker these days in Estonia. Grim memories of a nearly 15 per cent unemployment rate have recently given way to the more uplifting experience of double-digit real wage increases. The present state of the labour market has to be seen within the context of booming nearby Nordic economies. The Finnish unemployment rate has fallen to its lowest level since the late 1980s, and there is a strong upsurge in demand for construction workers all across the region. Intense competition with foreign employers for an increasingly scarce supply of workers has raised real wages, boosted confidence and fed into private consumption expenditure.

Estonia: GDP and inflation Year-on-year percentage change 14

14

SEB forecast

Inflation GDP

12

12

10

10

8

8

6

6

4

4

2

2

0

2000

2001

2002

2003

2004

2005

2006

2007

2008

Total employment, which had fallen steadily from its command economy peak of 840,000 in the late 1980s to an all-time low of 572,000 in 2000, has now climbed back to 646,000. Of these 74,000 new jobs, 39,000 were created in 2006 alone as retirees and discouraged workers were lured back into the labour force by higher wages. The total number of jobs is now back at a level last seen in 1994. Other labour market indicators are singing the same tune. Low unemployment has lifted the real wage growth rate from 4 per cent in the first quarter of 2005 to 11.2 per cent in the fourth quarter of 2006 – the highest in the past decade. Given our forecasts of sustained Nordic growth, we expect the Estonian labour market to remain tight for the next two years, with real wage growth rates coming down to a less remarkable 7 – 8 per cent.

0

Sources: Eurostat, Statistical Office of Estonia, SEB

For one, there has been a clear asymmetry in the perception of risks associated with the missed euro target. While residents’ nonchalance has barely been affected, there is surely a palpable sense of heightened risk among non-resident providers of capital, which gained further impetus from a mid-February brawl concerning Latvia’s currency. To the extent that two leading banks – Swedbank and SEB – are now more closely scrutinised by increasingly sceptical international capital markets as primary drivers behind the “Baltic economic miracle”, they are likely to yield to this pressure by further trying to apply the brakes to the present breakneck credit expansion. Other things being constant, that would be equivalent to a turnaround in the monetary policy stance with all the standard consequences of more restrictive lending, higher margins and elevated borrowing costs. However, other things need not remain unchanged, since

The rolling headline inflation rate has stayed within the 4.0 – 4.5 per cent corridor in the past two years, but the more volatile 12-month rate has recently tested a 5 per cent frontier. While this rate is not extraordinary for a fast-converging economy, it stands out against just 1 per cent achieved at the outset of 2004 and – more importantly – remains well above the Maastricht threshold. Moreover, the last few quarters have brought about unhealthy shifts among the three primary inflation-drivers. Given the exchange rate peg, productivity-based real appreciation is bound to

10

Estonia Eastern European Outlook — March 2007

remains a residual vulnerability which will be eliminated only when the euro is finally adopted.

take the form of an inflation differential above the euro area. But productivity advances are unlikely to account for the entirety of the latest price hikes. The economy’s high energy intensity exposed it to oil price increases in 2004 – 2005. While this impetus has now waned, it is increasingly being replaced by rising nontradables inflation. Booming property prices have finally lifted rents and found their way into headline inflation. In line with our baseline scenario of gradual subsiding external financing and consequent adjustments in domestic saving behaviour, we are lowering our inflation forecast to 4.0 per cent in 2007 and 3.5 per cent in 2008. Given an estimated 2.5 – 3.0 per cent Maastricht criterion, the inflation target will thus remain out of reach. Insofar as the authorities have not settled for a new accession date, 2010 is widely viewed as the earliest possible year.

Estonia: Gross external debt In per cent of GDP 90

90

Banks Total

80

80

70

70

60

60

50

50

40

40

30

30

20

20

10

10

0

97

98

99

00

01

02

03

04

05

06

0

Sources: Statistical Office, Bank of Estonia

Exchange rate risk revisited Although the export sector has largely retained its competitive position, the current account deficit (an 13.8 per cent of GDP in 2006) is too large to be sustained over the medium term. The current account deficit moved into double-digit territory at the end of 2002 and has remained there ever since. Persistently high external imbalances have led to ever higher external liabilities as a percentage of GDP. As a matter of common sense, this ratio is bound to hit an upper limit at some point, and its stabilisation will ultimately require a shift in the domestic saving-investment balance.

At some point, the edgy feeling among non-resident financiers is bound to spill over to residents and induce to them to review the assumptions underlying their consumption and investment patterns. This is when the new phase of the cycle will be set in motion. Insofar as residents will then develop a taste for local currency liabilities and euro assets, a longawaited monetary tightening (i.e. higher local currency borrowing costs) will take the form of customerdriven shifts in the banks’ balance sheets. Given the low prospects of a speculative market attack on the Estonian currency, we believe the key issue will be the speed and vehemence with which residents reassess their beliefs once the credit boom has run its course. While weakening confidence may occasionally manifest itself in commotions around currency exchange booths, the faith in the banking system’s fundamental health is a far more important matter. Given the long-term strategic interests of parent banks in the Baltic region, we consider the risks of a full-scale banking and currency crisis remote. A longer period of below-trend growth in order to bring debt-asset ratios to more sustainable levels is a better bet.

Gross external debt has climbed steadily, from 50 per cent of GDP in 1998 to 85 per cent in the third quarter of 2006. The main driving force behind the rapid accumulation of external debt has been the liabilities of banks. The gross external debt of the banking sector has risen from 18 per cent to 46 per cent of GDP over the same period. However, the associated vulnerability to sudden risks is less acute than these rather unappealing figures would suggest. Insofar as funding is from parent institutions, these credit lines are in fact FDI-like and therefore much less prone to rollover risks. To the extent that the perceived robustness of the currency board arrangement has encouraged residents to take advantage of a positive – but by now largely vanished – interest rate differential between the kroon and the euro, the banks have built up long foreign currency positions.

This assessment is based on the assumption of slower credit growth and prudent economic policy. There are, however, signs that the spendthrift habits of the consumers are increasingly overtaken by growthdizzy government. Thus the new four-party coalition is about to lower income tax and double pensions over the next four years. This would add fire to the already procyclical fiscal policy. Precisely at the wrong time.

Indeed, about 80 per cent of bank loans are in foreign currencies, with the corresponding shares for shortand long-term deposits being 30 and 40 per cent respectively. However, the long foreign currency position has been achieved at the cost of increased exposure to credit risks arising from the unhedged short foreign currency positions of non-banks. While the currency board system, in principle, alleviates the risks of open euro positions for all sectors, there

11

Latvia Eastern European Outlook — March 2007

and broadened its reserve requirements for commercial banks, but this has had limited impact on the consumption and lending boom, since 70 per cent of newly issued loans are denominated in euros. On March 15, 2007 the central bank supported the government’s efforts to curb inflation, raising the refi rate by further 0.5 percentage points to 5.5 per cent. Further action will depend on the success of the antiinflation plan in curbing price increases, consumption and lending growth. We expect the Bank of Latvia to continue to hike its key rate.

Persistent imbalances despite political action „ „ „

Feverish and imbalanced growth Severe current account deficit High inflation marginally down

Latvia is showing clear signs of overheating. Explosive growth has provoked huge current account deficits, persistently high inflation, increased labour shortages and wage hikes and a dramatic borrowing and consumption spree. Domestic and international concerns about the economy recently forced the government to come up with a programme to reduce inflation and the imbalances. Although we are not sure that this plan will help to substantially lower inflation and ease the imbalances, it has to be welcomed as a favourable signal from the government, business and society. Financial market nervousness will return if the plan remains a paper tiger and if the business and public sectors do not curb booming consumption.

The government’s programme to diminish inflationary pressures and achieve long-term sustainable growth was unveiled on March 6. The plan was developed by a group of experts representing ministries, commercial banks, the central bank and the social partners. Although most domestic and foreign experts agreed that it was too late to substantially improve the situation, the plan came at the right time to kill speculation about devaluation. Some measures in the programme will be implemented in the coming months, while many will involve medium-term action. The most important measures concern fiscal policy, the real estate market, lending, consumption and competition. There will be a fiscal tightening to balance the budget in 2007-2008 and achieve surpluses in 2009-2010, accompanied by moderate wage growth in the public sector and prudent public investments. No tax cuts are expected, though they were previous promised by the governing coalition. Higher taxes on speculative deals are expected in the property market, as well as differentiation of taxes and duties. To curb lending, there will be stricter requirements on documentation of income. The plan foresees a stepby-step decrease in inflation to 2.5-3 per cent in 2011, thus implying euro adoption in 2012 at the earliest.

During the winter, various foreign experts, credit agencies (Standard & Poor’s, for example, revised its outlook on Latvia to negative) and banks have predicted a growing risk of a hard landing. In the second half of February, rumours about a possible devaluation of the lats drove interbank rates from 4.5 up to 9 per cent. Although rates soon dropped back to 5.5 per cent, the lat is still near the upper boundary of its parity level (Latvia allows ±1% fluctuation around a central rate).

Latvia: Exchange rate EUR/LVL 0.7125

0.7125 0.7100

0.7100

0.7100

0.7075

In our opinion, the government will achieve its greatest success in fiscal tightening and reduction of lending, also making some progress in legalising the shadow economy, while its steps to calm and properly tax the real estate market are of questionable value and too late. In any event, the real estate market is already settling down and there is limited room for prices to rise further.

0.7075

0.7050

0.7050 Central parity, 0.7028 ± 1%

0.7025

0.7025

0.7000

0.7000

0.6975

0.6975

0.6960

0.6950

0.6950

0.6925 Jan

0.6925 Apr

Jul 05

Oct

Jan

Apr

Jul 06

Oct

Marginal slowdown expected

Jan 07

GDP grew by 11.9 per cent in 2006 and increased by an average of almost 9 per cent during 2001-2006. More than ever before, growth is driven by domestic demand — fuelled by growing personal income, bank loans, EU funds, untaxed proceeds from the sale of real estate, income gained through shadowy dealings and rather rosy expectations. The most prosperous industries are still the service sector and construction, while manufacturing is growing only half as fast. Due to the parliamentary election in 2006, the government

Source: Reuters EcoWin

The authorities denied that there will be any devaluation, calming the market. In the middle of March, the Bank of Latvia intervened, since the lat rate reached intervention level. The bank has always been firm about maintaining its peg. In 1998 and 1999 it defended the peg by selling hundreds of millions in foreign currency when the macro picture was much worse. In 2006 the bank increased its key interest rate twice

12

Latvia Eastern European Outlook — March 2007

forces in the growth of imports. Although public spending, business volume and consumption will grow at a slower pace, we do not foresee radical improvement in the current account. The deficit will fall only marginally, to 18 per cent of GDP in 2007 and 15 per cent in 2008.

was not in a particular hurry to solve economic issues through legislation, greater competition and lower inflation. Even taking into account the government’s latest anti-inflationary measures, more conservative credit assessments and labour shortages, GDP growth will slow only to 9.2 per cent in 2007 and 8.2 per cent in 2008.

Superheated labour market

Latvia: GDP and inflation

The labour force, productivity and wage growth are important factors in maintaining sustainable growth. The rapid economic upswing and large-scale emigration of the workforce to other EU countries have activated local labour reserves. Unemployment fell from 8.7 per cent in 2005 to 6.9 per cent in 2006. We expect these labour reserves to be exhausted within two years, while immigration policy will remain rather strict, resulting in a growing numbers of vacancies. All the above-mentioned factors pushed up wages by 23 per cent in 2006. It remains an open question whether Latvia can raise labour productivity quickly. In some sectors, like construction and services, productivity is lagging behind wage growth.

Year-on-year percentage change 14

14

SEB forecast

12 10

GDP

12 10

Inflation

8

8

6

6

4

4

2

2

0

00 01 02 03 04 05 06 07 Sources: Eurostat, Central Statistical Bureau of Latvia, SEB

08

0

Public finances remain sound. Tax revenue is growing faster than projected and the implementation of the anti-inflation plan will improve this. In 2006 there was a negligible fiscal deficit, because the huge year-end surplus was distributed within a few weeks by the government, which thus kept its pre-election promises. The government has a good chance of achieving a balanced budget as early as this year and a small surplus in coming years, as tax revenue is strong and public spending is expected to be more prudent.

High inflation is a major concern. Since 2004, inflation has been stuck above 6 per cent. Faint hopes during the second half of 2006 that the situation might change soon vanished and rising energy costs again pushed inflation upward. Consumer prices rose by 6.6 per cent in 2006, only slightly below the previous year’s level. It was particularly aggravated by rising food and housing costs, which together accounted for 2/3 of total inflation. The causes of inflation remain the same: a fast-growing economy, price convergence towards EU levels, rising living standards and income, an excess of demand over supply in various sectors, labour shortages, insufficient mechanisms to compensate for these shortages and a small domestic market with weak competition. In the next two years, inflation is expected to remain relatively high due to all the above-mentioned factors plus sharp rises in gas, heating and electricity tariffs.

The ruling coalition of four centre-right pa.rties led by Prime Minister Aigars Kalvitis (Peoples Party) felt comfortable having 58 votes of 100 and sometimes enjoying indirect support from the opposition leftists. The only pragmatic oppositionists, the New Era reformists, was totally ignored. The party lost the post of Mayor in Riga city and was pushed into opposition. However, recently the government’s attempt to get more direct control over national security got a negative reaction from the public and the President of Latvia, resulting to the possibility of a referendum. If it leads to early elections that would favour the opposition. Otherwise, the crucial issues for the cabinet in the coming years are the antiinflation programme and the Border Agreement with Russia.

Inflation will average 6.5 per cent this year and 5.8 per cent in 2008. A visible decrease of inflation could occur within 3-4 years, provided that strict measures are taken and the economy becomes more orderly. The overwhelming prevalence of imports over exports pushed Latvia’s current account deficit to an unprecedented 20.9 per cent of GDP in 2006. Foreign direct investments covered slightly more than a third of the deficit. Booming consumption pushed imports up by 29 per cent in 2006, while exports grew by 13 per cent. Export growth weakened in the second half of 2006, due among other things to lower demand for wood products in the EU. Moreover, Latvia will soon begin to utilise more of the EU funds allocated for the next several years, which are among the driving

13

Lithuania Eastern European Outlook — March 2007

During a recent visit to Lithuania, the International Monetary Fund mission pointed out that there has been a decline in export competitiveness as salaries have outpaced labour productivity growth. Basically, we share this view. However, Lithuania has few mechanisms to regulate wage growth. Attempts to limit pay increases in the public sector would cause highly qualified professionals to move to the private sector, encourage emigration of doctors and teachers and trigger a decline in the quality of public services. Agreements on smaller wage increases in the private sector are also hardly achievable, due to labour shortages.

Solid growth but accelerating inflation „ „ „

GDP growth starts to slow Inflation will set record for this decade in 2007 Budget in balance

In 2006, a four-year period of very rapid economic expansion approached its end. The Lithuanian economy is starting to face changes in its fundamentals. The trade and current account deficits have widened as export growth has gradually subsided while imports have continued to flourish. An economy cannot be eternally driven by its own domestic consumption boom; increasing trade and current account imbalances will, in the long run, deal a blow both to financial stability and to the domestic market itself. Thus, the economy has already peaked and growth will decrease slightly in 2007-2008. The export growth rate should slow, while import expansion will stay robust. Meanwhile, increased interest rates and decelerating growth in credit portfolios will have a negative effect on domestic demand. This process will be gradual and will not suddenly cool down the economy.

Real GDP rose by 7.5 per cent in 2006. Construction was the fastest growing sector, followed by manufacturing and financial intermediation. For several years, economic growth seemed to follow a straight line. The GDP increases in 2004, 2005 and 2006 reached 7.3, 7.6 and 7.5 per cent, respectively. On the other hand, some trends are present that paint future prospects as more clouded. Seven or eight months ago, we forecasted that growth would slow in the second half of 2006 as compared to the first half, and this proved true: in the first quarter, the rate of GDP increase was 8.5 per cent, while in the second, third and fourth quarters it was 8.4 per cent, 6.4 per cent and 6.9 per cent, respectively. The most important factor behind slower growth was the deterioration in net exports. A slowdown in manufacturing late in the year and a slump in agriculture had the largest negative effect on GDP growth. By way of comparison, during 2005 growth was accelerating.

Lithuania: GDP and inflation Year-on-year percentage change 12

GDP (LHS) Inflation (RHS)

SEB forecast

10

5 4 3

8

The current account deficit will reach 10 per cent of GDP this year and 8 per cent in 2008. Our previous forecast that GDP will increase by 7.0 per cent in 2007 and 6.5 per cent in 2008 is still realistic, though on the optimistic side. Private consumption and gross capital formation will remain key drivers, while the expectations of business and households will remain positive.

2 6 1 4

0

2 0

-1

2000

2001

2002

2003

2004

2005

2006

2007

2008

-2

Sources: Statistics Lithuania, Eurostat, SEB

In recent years, the Lithuanian and the broader Baltic “economic miracle” has been conditioned by a combination of favourable factors: the EU market has opened up fully, there has been an economic upswing in the formerly Soviet CIS countries, the macroeconomic environment has been stable, etc. All this, however, would have been not enough to achieve 7-8 per cent annual GDP growth without the lending boom. Credit activities follow the business cycle, and some signals showing a possible deceleration in banking activities have already started appearing. Price stabilisation in the residential property market squeezed the growth of the housing loan portfolio from 87 per cent in 2005 to 61 per cent in 2006. This year, the total credit portfolio should expand by 30-35 per cent; in 2006 it grew by 49 per cent.

Lithuania: Current account balance Per cent of GDP 0

0

-2

-2

-4

-4

-6

-6

-8

-8

-10

-10

SEB forecast -12

2000

2001

2002 2003

2004

Sources: Bank of Lithuania, SEB

14

2005

2006 2007

2008

-12

Lithuania Eastern European Outlook — March 2007

table”, rather than changes in the demand for labour. Demand-pull factors will continue to play a secondary role in inflationary processes. Thus the recent compensation for lost rouble savings (LTL 1.135 billion, or 5 per cent of country’s annual wage bill) should have no adverse effect on the consumer price index. The same holds true for the effect of a possible personal income tax cut from 27 to 24 per cent.

In the next couple of years, the future of the second reactor at the long-obsolete Ignalina nuclear power plant and the new nuclear power plant construction project will remain a vital issue in the economy. It is becoming more and more obvious that Lithuania may suffer an energy shock. A shutdown of the Ignalina reactor at the end of 2009, with a new power plant starting operation only in 2015-2016, would mean that the country would have to survive without nuclear power for 5 to 6 years. Demand for natural gas would significantly increase, and it is difficult to forecast the price of gas. Last but not least, environment pollution would worsen. GDP growth would decrease due to lower energy production and faster inflation.

Recently, the central bank and the Ministry of Finance have considered some actions to preclude further acceleration of inflation. Firstly, any automatic indexation of salaries should be avoided. The government intends to use windfall revenues to reduce the budget deficit. The central bank is committed to applying stricter standards of capital adequacy and reserve requirements than in the euro zone. Also, there is ample room to improve control of administratively established energy prices.

Increasing price pressure In 2006, average annual inflation was 3.8 per cent. Unlike in previous years, there was a major rise in food prices: 8.1 per cent. Utility prices rose even faster at 10.3 per cent. Keen international competition helped lower clothing prices by 3 per cent. Thanks to lower global oil prices, there was only a moderate increase in transport costs.

In 2006, the fiscal deficit was slightly lower than we forecasted in last autumn’s Eastern European Outlook. According to preliminary data, the budget was more or less balanced. The 2007 budget includes a conservative projection of revenues from personal income tax. We believe that the fiscal situation will be very much like that in 2006 with actual revenues exceeding projections and the fiscal deficit being only of a symbolic size.

The above-mentioned changes confirm that Lithuanian inflation is driven mostly by cost-push factors. Food products were especially sensitive to the surge in prices of agricultural products and higher costs in the food processing and distribution system. Meanwhile, demand-pull factors had little effect on food price inflation.

The key political event in early 2007 was the local elections held on February 25. On the one hand, it was a good opportunity for the political parties to test their popularity before the parliamentary election scheduled for the autumn of 2008. On the other, the election results showed public attitudes towards the activities of the existing municipal councils and city mayors.

In 2007, inflation will hit a record for this decade of 4 per cent or even a bit higher. The rise in consumer prices will be mainly spurred by higher natural gas, heating and electricity prices; an increase in tobacco excise duties; and higher unit labour costs.

Lithuania: Wages

The election did not indicate any obvious trend. Formally it was won by the conservative Homeland Union party. However, the ruling Social Democrats were very close behind in the number of votes and actually outscored the conservatives in terms of seats on municipal councils. Given the victory of the conservatives and Social Democrats at the municipal level, the two parties can be expected to be the main rivals once again in next year’s parliamentary election.

Year-on-year percentage change 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 01

02

03

04

05

06 Source: Statistics Lithuania

In the fourth quarter of 2006, wages were up by 19.1 per cent year-on-year. We expect pay increases of 15 per cent in 2007 and 13 per cent in 2008. The main reason behind slower wage growth will be less room for continued legalisation of wages paid “under the

15

Theme: Overheated in the Baltics Eastern European Outlook — March 2007

However, overheating may be a more serious issue than the inflation figures suggest. In small open economies, domestic demand pressures are as likely to show up in wider current account deficits as in higher inflation. Thus, perhaps the unstoppable accumulation of external imbalances, fuelled by credit growth and pro-cyclical fiscal policies, is where the most visible signs of overheating are to be found. Again, Latvia stands out, with an average current account deficit that has almost doubled from a sustainable 7.5 percent of GDP to 14.5 per cent. While the other two Baltic economies have also accumulated debt, Lithuania has, up to last year, so far been able to keep its current account deficit in single-digit territory.

Credit growth must come down „

„ „

Most heat being generated by birth of Baltic retail banking market Credit cycle peaking Latvia most overheated

The Baltic economies are sizzling. In Estonia and Latvia, yearly growth rates have been in double digits since 2005. Confidence surveys and real wage growth are reaching their highs for the decade, asset prices are going through the roof and unemployment is about to be erased from the economic vocabulary. Since at least mid-2006, however, a growing chorus of dissenting voices has claimed that the current pace of expansion is not sustainable and that the three economies display increasingly alarming symptoms of overheating. This implies that aggregate demand is outpacing supply and, as a result, mounting capacity bottlenecks are bound to hamstring the present pace of expansion.

The Baltic countries: Indicators of overheating Per cent 16

16

Estonia Latvia Lithuania

14

The overall conclusion from a reading of three conventional indicators of overheating – economic growth, inflation and current account balance – is that in the past three years, the Baltic economies have indeed undergone a major growth surge. In 20012003 there was little cross-regional variability in economic growth rates, but in 2004-2006 Latvia and Estonia forged ahead. Their average growth rates climbed two percentage points, while that of Lithuania actually declined (from 7.9 to 7.5 per cent). Capacity constraints are higher than at any time this decade, and severe labour shortages have caused real wages to skyrocket. In all three economies, unemployment is falling to levels not seen since the early 1990s. Strong demand for labour coupled with a natural population decline and a negative net balance of international migration have pushed Estonian real wage growth above 10 per cent. The other two economies are experiencing similar labour cost pressures.

14

12

12

10

10

8

8

6

6

4

4

2

2

0

2001-2003

2004-2006

GDP growth

2001-2003

2004-2006

Inflation

2001-2003

2004-2006

0

Current account/GDP

Sources: National statistical offices, SEB

Heavy and increasing dependence on foreign savings has to be seen against the backdrop of deepening integration with EU product and financial markets. Catching-up economies are expected to run larger external deficits because of their more rapid growth prospects. In a dynamic framework, current account sustainability depends on expectations of future domestic and world growth, a country’s cost of borrowing and the sensitivity of trading partners to relative price changes of locally produced goods. Hence, if the expected growth differential with the rest of the world is sufficiently high, a country could get away with a fairly high external deficit. Low borrowing costs would have the same effect. The commodity structure of exports is equally important. If a country competes primarily on the basis of cost, real appreciation associated with the convergence will have a relatively large adverse impact on its external deficit.

Higher inflation Inflation performance has deteriorated in all three countries, although in Estonia only to a minor extent. On the other hand, Latvia’s average inflation rate shot up from 2.5 per cent in 2001-2003 to 6.6 per cent in 2004-2006. Although the Lithuanian inflation rate has also risen perceptibly, it is still the lowest of the three countries. With the possible exception of Latvia, Baltic inflation rates are not extreme for fast-converging economies. The problem is, however, that they are too high to meet the Maastricht criterion for euro zone accession and are creating extra uncertainty about future exchange rate arrangements.

Thus, the sharp deterioration in the external position of the Baltic countries is largely an expectationsdriven phenomenon. Insofar as non-resident lenders and resident borrowers have formed their expectations in a backward-looking manner, the recent large reported growth differential may have led to unrealistic beliefs about its durability. Even if today’s current

16

Theme: Overheated in the Baltics Eastern European Outlook — March 2007

Whatever the theoretical merits of this argument, we think that – given our optimistic global scenario – the Baltic countries’ currency pegs will have a good chance of survival. Firstly, although growth has undoubtedly been skewed towards domestic sources in recent quarters, robust export growth rates indicate that there has not yet been a massive misallocation of resources. There are, however, signs that cost pressures are taking their toll. In 2006 export growth rates fell in all three economies — in Latvia quite spectacularly (from 34 to 13 per cent). Hence, the longer the adjustment is delayed, the stronger the subsequent pressure on the exchange rate. Secondly, if the Nordic economies continue to grow at a brisk pace, relative price disadvantages will be offset by persistently strong demand from these countries. This will probably give Baltic exporters some extra leeway in adjusting to harsher realities.

account deficits may be sustainable given expectations of continued strong economic growth (admittedly a big if), less optimistic expectations could call their sustainability quickly into question. Moreover, rapid convergence associated with large-scale use of foreign savings is likely to exert a feedback effect on growth expectations, as worries about heightened financial vulnerabilities come to the fore.

Trapped in a credit cycle There is, however, one single factor behind both actual and expected growth performance – the spectacular drop in the cost of credit. Whatever beliefs residents may have had during the 1990s about their income growth and future opportunities, there was little room for inter-temporal substitution in a double-digit interest rate environment. Around 2000, liquidity constraints began to collapse, first in Estonia, then in Latvia and finally in Lithuania. By 2002 money market interest rates in the three countries were less than 90 basis points above Euribor (compared to almost 2000 basis points only three years earlier). The ready availability of cheap cash unleashed the private sector’s pent-up demand for goods. The resulting surge in domestic demand boosted growth rates, real wages and, perhaps most importantly, projections of permanent income. Upwardly revised expectations about future consumption led, in turn, to a new phase of the cycle.

Baltic countries: Private credits Year-on-year percentage change

Insofar as all three countries seem to be testing the outer limits of financing constraints, two major factors behind the credit boom are likely to gradually fade. If borrowing costs will not rise because of more restrictive lending, increased uncertainty surrounding the exchange rate arrangements of the Baltic countries will, at some point, show up as greater demand for local currency liabilities and foreign currency assets on the part of the non-bank private sector. These shifts will then gradually re-introduce interest rate differentials and cause resident borrowers to reestimate their life-time incomes. At this point the credit cycle will turn, as sober assessments of future income would then decrease the demand for goods and labour and limit the growth of real incomes.

100

100

75

75

50

50

25

25

0

0

-25

-25

-50

-50

-75

-75 95

96

97

Lithuania

98

99

00

Latvia

01

02

03

04

05

06

Estonia Source: IFS

An examination of credit growth rates suggests that the high point of the cycle may already be past. In Estonia and Lithuania, the twelve-month growth rate of private credit peaked in mid-2006, and in Latvia growth also seems to have stabilised. However, while slowing, the credit expansion is still far too rapid to be sustainable in the medium term. Given the competing soft and hard landing scenarios, for Latvia and Estonia with the hard landing involving substantial stress on the currencies and possible devaluation, we anticipate a gradual revision of growth expectations, with accompanying slower growth and easing of external imbalances over a period of 2-3 years. But this forecast assumes a continued slowdown in credit expansion. Should the latter experience a further boost – an outcome we consider unlikely at the moment – the probability of a more violent adjustment can only rise. In Latvia, authorities recently came up with a restrictive antiinflation package. Given the increasing awareness of the threats associated with the present boom, the other two Baltic governments may soon follow suit.

When this happens, the flexibility of the Baltic economies will be put to the test. A drop in domestic demand would call for a shift of resources from the non-tradable into the tradable sector. This is the point at which the exchange rates of the Baltic countries may experience downward pressure. In principle, restoration of lost competitiveness can occur either via stagnating wages and prices or one-off changes in the exchange rate. To the extent that it is easier to change one price rather than a multitude of them, devaluation is often viewed as an attractive way out of an exporter’s predicament.

17

Poland Eastern European Outlook — March 2007

dise exports, mainly construction materials and pharmaceuticals. The latter make up roughly one half of exports to Russia. The intended embargo is widely interpreted as Russia’s reaction to Poland’s veto of the “energy charter” between Russia and the EU. Poland blocked the negotiations after Russia had imposed an embargo on Polish meat products at the end of 2005.

Growth above trend Strong domestic demand Great need for tightened public finance Euro adoption no earlier than in 2012

„ „ „

In 2006, the Polish economy was characterised by fast growth, low inflation and a relatively narrow current account deficit. This year, GDP growth will remain at a high level thanks to a continued increase in private consumption and large fixed capital spending. Rapid growth and rising wages will put an end to the moderating trend in prices. The recent pattern of vigorous domestic demand triggering a deterioration in external accounts may strengthen somewhat. While not a reason for immediate concern, populist public spending and the political dependence of the National Bank of Poland (NBP) should be watched closely. Setting a definite date for euro adoption could serve as an anchor for sound economic policy and reforms.

Large inflow of EU funds In 2008, GDP growth will be somewhat less than in 2007 but will stay above the trend level of 4-5 per cent. Both cyclical and structural factors will be the main drivers. If Poland improved its absorption of EU structural funds from less than 50 per cent in 2006 to 100 per cent, its economic growth would be even faster, possibly 7.0 per cent. Poland is the largest net recipient of money from the 2007-2013 EU budget. The EU funds should be one of the main factors sustaining large investment expenditure. Export growth started to lag behind import growth in the second half of last year, thus interrupting the narrowing trend in the current account deficit. In the third quarter of 2006, the current account deficit measured 1.4 per cent of GDP, close to our full-year forecast. This year it will deepen further, with a negative contribution from net exports. Nevertheless, substantial inflows of EU funds and remittances from Polish emigrants will keep the current account deficit at one of the lowest levels among new EU members.

Poland: GDP and its components Year-on-year percentage change 15

15

10

10

5

5

0

0

-5

-5

-10

-10

-15

Despite fast growth and adverse labour supply effects caused by emigration, unemployment remains the highest in the expanded EU (15.1 per cent in January). In 2007 and 2008 the jobless rate will shrink further, but at quite moderate speed due to a high degree of structural unemployment.

-15 Q1

Q3 Q1 Q3 Q1 02 03 GDP Private consumption

Q3 Q1 Q3 Q1 Q3 04 05 06 Public consumption Fixed capital formation Source: Central Statistical Office

Last year’s average annual HICP inflation was 1.3 per cent, one of the three lowest in the EU. Despite emerging labour shortages in certain economic sectors, productivity growth offset wage growth, thus taming inflationary pressures. This year inflation will go up, however. In addition to higher excise taxes on gasoline and cigarettes imposed in January, inflation will accelerate due to demand-pull factors.

Last year GDP growth was 5.8 per cent, the highest since 1997. The buoyant dynamics of exports finally started to translate into domestic demand, mainly fixed capital formation. The country’s EU accession in 2004 prompted huge inflows of foreign direct investment and demand for Polish goods. Record-low interest rates as well as inflows of EU structural funds boosted investment expenditure, and more intense hiring of labour encouraged private consumption.

The key issue within the NBP’s Monetary Policy Council is whether inflation will exceed the upper band of its 2.5 +/- 1 per cent target range, based on headline annual inflation measured as CPI. Recently the annual inflation rate mainly hovered below target, but it squeezed back into the preferred range in January (1.7 per cent). Taking this into account, in February the MPC left the reference rate unchanged at its 4 per cent record low, where it has remained for 12 consecutive months. The MPC’s accompanying statement was very similar to that of the previous

In 2007, GDP will grow at the same pace as last year. The economy will keep accelerating; in OctoberDecember 2006 it speeded up year-on-year for the seventh consecutive quarter, reaching 6.4 per cent. Around mid-year it will slowly start losing momentum, mainly due to statistical base effects and a lack of additional stimulus. Recently tense Polish-Russian relations may also hamper GDP growth, due to slower exports. According to the Russian press, Russia is considering an additional embargo on Polish merchan-

18

Poland Eastern European Outlook — March 2007

government boosted spending more than the nominal GDP growth assumed in the budget and left the same PLN 30 billion deficit cap in place. By April of this year, the authorities have to comply with an EU accounting rule that stops them from classifying transfers to private pension funds as state revenue. As a result, the fiscal deficit to GDP ratio will be roughly 1.9 per cent deeper. Thus the deficit will not reach the 3 per cent threshold of the euro zone convergence criterion, either in 2007 or 2008.

month. According to the central bank, there is not enough solid evidence that strong economic growth is threatening its inflation target.

Poland: Inflation Year-on-year percentage change 5.0

5.0

4.5

4.5

4.0

4.0

3.5

3.5

3.0 2.5 2.0

3.0

If there were enough political will, Poland could fulfil all the Maastricht criteria with relative ease. And if the government set a clear target date for joining the euro zone, this would be a sign of a shift towards solid economic reforms, above all in the sphere of public finance. However, this is not likely to happen before the parliamentary election, scheduled for autumn 2009. We do not regard euro adoption as likely earlier than 2012. The only clear thing today is the government’s intention to hold a referendum on euro adoption in 2010, despite the disapproval of Brussels and Poland’s commitment to join the euro zone when accepting EU membership in 2004.

2.5

Central bank's target range

2.0

1.5

1.5

1.0

1.0

0.5

0.5

0.0

0.0 02 04 06 08 10 12 02 04 06 08 10 12 02 04 06 08 10 12 04 05 06 07 Source: Central Statistical Office

Headline inflation (CPI) will peak in the second quarter of this year, at close to the central bank’s target. Then the MPC will hike the reference rate by 25 basis points (from 4 to 4.25 per cent) after releasing a new inflation report in July. High unemployment and tough global competition will limit the speed of wage increases, while continuous productivity growth should be maintained given buoyant investment expenditure. Thus, despite the predicted acceleration, inflation should stay within safe territory, meaning no additional interest rate hikes in 2007.

Poland’s wobbly coalition government is currently its largest economic risk factor. The appointment of the central bank governor and the 2007 budget were two recent sources of tension within the coalition. Future areas of government disagreements will be public spending, energy, property restitution and privatisation. Although a premature parliamentary election cannot be entirely ruled out, we do not foresee one taking place in the near term. Local elections in November 2006 led to an outcome very close to the current parliamentary situation. Thus, no political parties are sure they would win early elections.

Since the appointment of Slovomir Skrzypek as Poland’s new central bank governor in January 2007, the balance of votes in the MPC has shifted in favour of the doves. At present, seven out of the ten MPC members back a “neutral” monetary policy stance. The market views Skrzypek as having neither a sufficient academic background nor enough experience in monetary policy to form his own firm opinion as to where interest rates should be heading. Even worse, Skrzypek’s close ties with President Lech Kaczyncki and the government are likely to trigger concerns about the central bank’s independence.

Despite political uncertainties, early this year Fitch Ratings upgraded Poland’s classification. The country’s creditworthiness is improving due to its strong growth as well as low external financing risks. This year the zloty will strengthen due to solid economic fundamentals. However, in the course of the year the currency may temporarily drop against the euro as a response to political turmoil or fiscal easing.

The 2006 fiscal deficit was markedly below the government’s target. It reached PLN 25 billion and was PLN 5 billion lower than projected. The betterthan-targeted fiscal balance was good news on the surface, but a closer look reveals some major weaknesses in the planning process. Despite much faster than expected GDP growth, the revenue surplus above plan in 2006 was half that of 2005. Similarly, the government overestimated certain expenditures such as subsidies on agricultural fuel and family allowances. Poland’s strong economic performance will ensure sufficient budget revenues at least in the short run, thus providing favourable conditions for fiscal reforms. The approved 2007 budget contains no major steps towards fiscal tightening, however. The

19

Slovakia Eastern European Outlook — March 2007

gas and heating prices and a strong koruna are all contributing to lower inflation. Decreases in regulated prices and lower fuel and service price expectations are lowering inflation forecasts. Food prices remain almost the only concern. Inflation will drop to 2.5 per cent in 2007 and 2.3 per cent in 2008. Thus there is a high probability that the country will meet the Maastricht inflation criteria in 2009.

Record-breaking growth „ „ „

Sentiment indicator at new all-time high Increasing chance of euro introduction by 2009 Continued strong koruna also after revaluation

The euro adoption target requires stronger fiscal discipline, since the budget deficit is still above 3 per cent of GDP. Although the government has carried out some of its pre-election promises, fiscal planning and controls have tightened. Also yielding a positive impact were a reform in public finance and the introduction of a flat tax that has been accepted by households. Parliament easily approved the 2007 central government budget. Tax revenue is expected to increase more than planned, but spending will also tend to increase. The government intends to trim capital spending in favour of domestic consumption. Strong economic growth will allow a lowering of the public sector budget deficit from 3.4 per cent last year to 3 per cent in 2007 and 2.8 per cent in 2008.

Slovakia’s economic growth and prospects have never been better. The country certainly has the fastest growth in Central Europe. The probability of joining the euro zone is increasing as inflation slows, but the fiscal deficit remains a challenge. In order to achieve more balanced growth, fiscal consolidation and continued labour market reform are needed. However, political stability is supporting the positive trends in the economy. Public administration has improved, the tax system has been simplified and foreign investment is warmly welcomed. The economy grew by almost 10 per cent in the second half of 2006 and by 8.3 per cent for the year, primarily driven by export-oriented manufacturing (cars and electronics) but also by continuing expansion in domestic demand. The economic sentiment indicator rose to a new high. We expect continued strong growth in the next few years, mainly due to brisk export growth. Household demand and fixed capital investment will grow somewhat more slowly. GDP growth will reach 8 per cent in 2007 and 6.5 per cent in 2008.

The koruna has appreciated sharply since autumn, moving towards the lower boundary of the central ERM2 parity level. Thus, the central bank has tried to ease the appreciation pressure on the SKK. On March 19, Slovakia revaluated by 8.5 per cent to a new central parity at 35.4424 against the euro. However, with strong fundamentals such as healthy growth and low inflation, the koruna will remain under strong upward pressure. The central bank has not changed its key interest rate since September 2006, since current economic developments are in line with its mid-term forecast. We expect the key rate to be cut to 4.25 per cent in the second half of the year.

The current account deficit decreased only slightly in 2006 but is not a threat, since there were also massive foreign direct investment inflows, mostly in car production. Expected strong export growth will help cut this deficit greatly in the next few years, thanks to accelerated car production by the PSA and Kia factories. Samsung also recently decided to invest in Slovakia, confirming the competitiveness of the country. In 2006, FDI inflow was twice as large as in 2005, covering 2/3 of the current account deficit. This deficit will shrink from 7.9 per cent in 2006 to 4.5 per cent in 2007 and 3.5 per cent in 2008.

Government surprisingly strong Contrary to expectations the rainbow coalition consisting of the left-wing populist party Smer-SD led by Prime Minister Robert Fico, the former communists and the nationalist Slovak National Party has strengthened its position, maintaining a popularity of above 60 per cent. The coalition also won the recent local elections. Although the government, which came into power in June 2006, opposed many of its predecessor’s reforms, it is still maintaining the goal of introducing the euro in 2009. It has not made any major changes in the previous government’s reforms aimed at improving the business environment and attracting foreign investments. A budget tightening is necessary, but this goes against the government’s pre-election promises to expand the welfare state and cut taxes.

The rapid economic growth has resulted in recordhigh employment. Reductions in social benefits and stricter rules that force the unemployed to seek jobs faster contributed to a drop in unemployment from 18 per cent in 2004 to 13.5 per cent in 2006. The continued outflow of labour also decreased the jobless rate. Nevertheless long-term unemployment remains a serious problem and is the highest in the EU. Wage increases are not a big concern, as productivity growth is faster. Inflation is no longer the biggest obstacle on the road to euro adoption. Slovakia is sticking to its 2009 euro zone entry target. Benign fuel prices, base effects in

20

The Czech Republic Eastern European Outlook — March 2007

coming months due to housing deregulation, tobacco taxes, food prices and services. We expect inflation to remain slightly below 3 per cent: at 2.8 per cent in 2007 and 2.7 in 2008.

Past its peak „ „ „

Domestic demand the key driver Inflation below central bank target Concerns about political stability remain

Modest inflation keeps rates low The CNB has not raised its key interest rate since September 2006 but has maintained it at 2.5 per cent, the lowest in the EU. A sharp decline in inflation and the strengthening of the koruna are keeping the central bank in a wait-and-see position. However, the prospect of higher inflation will trigger an increase in the key rate to 3 per cent by the end of the year.

The peak of the business cycle is past, and the growth of the Czech economy is slowing. Inflation remains well below the target of the Czech National Bank (CNB) but with a rising trend in the coming months. The main risk lies in continued political instability, since the new government lacks a majority in Parliament to introduce its reforms. The government has not set a new euro zone entry target date, but it will not be earlier than 2011. The Czech economy has maintained steady growth, driven by accelerating household consumption and robust investment activity. Manufacturing industry is performing well, fuelled by investments in exportoriented capacity. The contribution of net exports to GDP was slightly negative, due to a rise in imports driven by increasing domestic demand. Consumption is burgeoning, fed by solid wage growth, cheap loans, rising employment and strong consumer confidence.

Public finances are still the Achilles heel of the Czech economy, due to the lack of consensus among politicians. The fiscal deficit exceeded 3 per cent of GDP, mainly due to extra spending on pensions. The 2007 central government budget draft — reflecting the fragile situation in Parliament — avoided a restrictive budget regime and supported social spending. One significant budget risk is hidden in the planned income from the privatisation of the large energy company CEZ, which is uncertain both in terms of timing and size. Therefore we expect the fiscal deficit to remain above 3 per cent in 2007 and 2008.

We expect economic growth to moderate to 4.8 per cent in 2007 and 4.5 per cent in 2008.

Political uncertainty remains After eight months of political crisis, a new coalition of the centre-right Civic Democratic Party (ODS), the centrist Christian Democrats and the Green Party — led by Prime Minister Mirek Topolanek — won a parliamentary vote on January 19. However, political uncertainty will persist, since the coalition has only 100 of the 200 seats in Parliament and enjoys only the shaky support of two renegade MPs. There is a limited chance that the government can push through a package of economic and social reforms. The probability of early elections is thus high.

Higher repatriation Last year foreign trade reached a record-breaking surplus, with machinery and cars as the main contributors. In spite of this, the current account deficit more than doubled due to deterioration in the balance of services and unexpectedly large shortfalls in the income balance, since profits were repatriated by foreign investors. The current account deficit will decrease only marginally in the next couple of years, due to a continuous outflow of profits from wellperforming foreign-owned companies. Unemployment continued to shrink last year due to strong demand for labour. However, there were still structural imbalances, since long-term unemployment continued to rise. Although the growth in real wages was the highest in the past three years, productivity growth was even higher, especially in manufacturing. Inflation was low in the second half of 2006, mainly due to the earlier strengthening of the koruna and harsh competition in the retail trade. The CNB lowered its inflation target to 2 per cent as from 2010, hoping to reduce inflationary expectations. A revision of the consumer basket will give housing costs, transport and tobacco a larger impact on inflation, while the role of food and clothing will diminish. The net effect of these changes will probably be slightly higher price increases. Inflation will increase in the

21

Hungary Eastern European Outlook — March 2007

Gyurcsány managed to survive a parliamentary confidence vote. In February, Gyurcsány received additional support from his party, being elected to head the Socialist Party by a large majority of votes. Despite a comparative easing of political tensions, the government remains rather vulnerable. Opinion polls reveal that the popularity of the ruling coalition is at record lows and that there is increasingly high support for opposition parties. The repercussions of the government’s fiscal austerity package are the main factor behind public disapproval of the ruling parties.

Combating twin deficits „ „ „

Fiscal consolidation taking place Slowing growth, faster inflation Government gaining credibility, but not popularity

The rigorous fiscal reforms applied since September 2006 are starting to hamper economic expansion and push up inflation. Real GDP growth slowed down to 3.9 per cent in 2006, and inflation rose to 4.0 per cent. Growth and inflation are yet to get worse in 2007. However, fiscal consolidation is proceeding rather successfully and should drive Hungary’s twin deficits to slightly less worrisome levels this year.

Tightening continues Last year seems to have been the first since 2001 that the government did not breach its planned budget deficit limit. The government’s forecast for 2006 was 10.1 per cent of GDP (ESA’95 standard, pension costs included), while the preliminary results came in at 9.6 per cent of GDP. Thus, despite the deficit still being huge, the government is starting to prove its credibility and its determination to deal with the imbalances.

In 2006, growth was mainly driven by external demand. Exports were helped a lot by a relatively weak forint and favourable developments in the euro zone, Hungary’s most important trading partner. Domestic demand decreased slightly in absolute terms as fiscal tightening started to bite.

Almost on a weekly basis, EU officials continue to press the Hungarian authorities to tackle imbalances. We predict that the government will continue to move in the right direction, with further implementation of fiscal austerity measures that were approved in the summer of 2006. The public deficit should shrink to 6.5 per cent of GDP this year and 4.5 per cent in 2008. Under such a scenario, the Maastricht criteria might be met in 2010, permitting euro adoption in 2012. Allowing for some fiscal or inflationary slippage, 2014 is a realistic target for euro zone membership. Lately the government has declared its intention to approve a euro introduction plan by mid-2008 and to join the euro zone between 2010 and 2015.

This year, GDP growth should slow sharply to 2.3 per cent and remain rather weak in 2008 at 2.8 per cent. In the next few years, external demand will continue to drive economic growth in Hungary, since domestic demand will be depressed by fiscal consolidation and still relatively high interest rates. In the first nine months of 2006, the current account deficit was a rather high at 8.6 per cent of GDP. The positive effect of improved net exports was easily offset by large outflows of foreign direct investment income. However, the beneficial impact of exports in the fourth quarter probably shrank the current account deficit to around 7.5 per cent of GDP for the whole year. In the next few years, smaller outflows of FDI income can be expected, due to improved investor sentiment towards Hungary. Net exports should also contribute positively to the current account, thus bringing the deficit down to 5.5 per cent in 2007.

Dovish atmosphere building up During 2006, the National Bank of Hungary was particularly hawkish and raised its base rate from 6 to 8 per cent in order to fight the weak currency and inflationary risks. At the beginning of March 2007 a new central bank governor, András Simor, succeeded Zsigmond Járai. The new head of the NBH is expected to be more dovish than his predecessor. In line with lower inflation in the second half of 2007 and suppressed growth, the central bank should start cutting interest rates in the third quarter of 2007, reaching a base rate of 7 per cent by the end of the year. Improved sentiment towards the forint will support the Hungarian currency, which will strengthen to HUF 245 per EUR in late 2007.

Inflation surged to 8.4 per cent year-on-year in January, driven by higher taxes and the elimination of subsidies on gas, transport, medicines etc. Price growth should peak at 9 per cent in March 2007. Thus far, lower oil prices, a stronger forint and subdued domestic demand are helping to mitigate the negative impact of fiscal tightening on inflation. In the second half of this year, inflation is expected to ease due to statistical base effects, but for the whole year it will remain high, amounting to 7.0 per cent. In 2008, average HICP inflation should slide to 4.3 per cent due to favourable base effects and weak demand. Last autumn’s political turbulence was replaced by relative tranquillity after Prime Minister Ferenc

22

Key economic data Eastern European Outlook — March 2007

CZECH REPUBLIC 2001 GDP, % 2.5 Inflation, average, % 4.5 Unemployment, % 8.1 Current account, % of GDP -5.3 Public sector financial balance, % of GDP -5.8 Public sector debt, % of GDP* 25.1 EUR/CZK, end of period 31.70 Key rate, eop 4.75 5-year government bond, eop 4.70

2002 1.9 1.4 7.3 -5.5 -6.8 28.5 31.50 2.75 3.10

2003 3.6 -0.1 7.8 -6.2 -6.6 30.1 32.40 2.00 3.70

2004 4.2 2.6 8.3 -6.0 -2.9 30.7 30.30 2.50 3.40

2005 6.1 1.6 7.9 -2.1 -3.6 30.4 29.00 2.00 3.20

2006(f) 6.1 2.1 7.7 -4.5 -3.8 30.5 27.50 2.50 3.30

2007(f) 2008(f) 4.8 4.5 2.8 2.7 7.2 6.8 -4.0 -3.8 -4.0 -3.5 31.2 31.5 27.30 27.00 3.00 3.50 3.80 4.00

2002 8.0 3.6 10.3 -10.6 1.0 5.6 15.60 3.50

2003 7.1 1.4 10.0 -11.6 2.4 5.7 15.60 2.60

2004 8.1 3.0 9.7 -12.5 1.5 5.2 15.60 2.40

2005 10.5 4.1 7.9 -10.5 1.6 4.5 15.60 2.60

2006(f) 11.4 4.4 5.9 -13.8 1.9 4.0 15.60 3.90

2007(f) 2008 (f) 8.0 7.0 4.0 3.5 6.5 7.0 -12.0 -11.0 0.9 0.5 3.7 3.5 15.60 15.60 4.30 4.50

2002 4.3 5.2 5.8 -7.0 -9.0 55.6 235.90 8.50 7.10

2003 4.1 4.7 5.9 -8.7 -7.2 58.0 262.20 12.50 9.30

2004 4.9 6.8 6.1 -8.8 -6.5 59.4 245.90 9.50 8.00

2005 4.2 3.5 7.2 -7.4 -7.8 61.7 252.70 6.00 7.10

2006(f) 3.9 4.0 7.5 -7.5 -9.6 68.5 252.30 8.00 7.40

2007(f) 2008(f) 2.3 2.8 7.0 4.3 8.0 7.8 -5.5 -5.0 -6.5 -4.5 72.0 73.0 245.00 240.00 7.00 6.50 7.00 6.20

ESTONIA 2001 GDP, % 7.7 Inflation, average, % 5.6 Unemployment, % 12.6 Current account, % of GDP -5.2 Public sector financial balance, % of GDP 0.3 Public sector debt, % of GDP 4.7 EUR/EEK, end of period 15.60 3-month interest rate, eop 4.00

HUNGARY 2001 GDP, % 4.1 Inflation, average, % 9.1 Unemployment, % 5.7 Current account, % of GDP -6.1 Public sector financial balance, % of GDP -4.1 Public sector debt, % of GDP 52.1 EUR/HUF, end of period 246.30 Key rate, eop 9.75 5-year government bond, eop 7.80

(f) = forecast

23

Key economic data Eastern European Outlook — March 2007

LATVIA GDP, % Inflation, average % Unemployment, % Current acccount, % of GDP Public sector financial balance, % of GDP Public sector debt, % of GDP EUR/LVL, end of period Key rate, eop 5-year government bond, eop

2001 8.0 2.5 13.1 -7.6 -2.1 13.7 0.56 3.50 8.00

2002 6.5 2.0 12.0 -6.6 -2.3 13.2 0.61 3.50 5.50

2003 7.2 2.9 10.6 -8.1 -1.2 14.4 0.67 3.00 4.60

2004 8.6 6.2 10.4 -12.9 -0.9 14.5 0.70 3.50 4.00

2005 10.6 6.9 8.7 -12.4 0.2 11.9 0.70 4.00 3.20

2006(f) 11.9 6.6 6.9 -20.9 -0.3 9.7 0.70 5.00 4.90

2007(f) 2008(f) 9.2 8.2 6.5 5.8 5.8 5.2 -18.0 -15.0 -0.1 0.2 9.3 9.0 0.70 0.70 6.00 6.25 5.40 5.70

2001 6.6 1.6 17.4 -4.7 -2.0 22.9 3.53 5.30 5.80

2002 6.9 0.3 13.8 -5.1 -1.4 22.3 3.45 3.50 4.60

2003 10.3 -1.1 12.4 -6.8 -1.2 21.2 3.45 2.70 3.60

2004 7.3 1.2 11.4 -7.7 -1.4 19.4 3.45 2.60 3.00

2005 7.6 2.7 8.3 -7.2 -0.5 18.7 3.45 2.50 3.10

2006(f) 7.5 3.8 5.6 -11.0 -0.5 18.2 3.45 3.80 3.90

2007(f) 2008 (f) 7.0 6.5 4.0 3.0 5.9 6.1 -10.0 -8.0 -0.5 -1.0 17.0 16.0 3.45 3.45 4.50 4.50 4.60 4.60

2001 1.1 5.3 18.2 -2.9 -3.7 36.7 3.52 11.50 9.50

2002 1.4 1.9 19.9 -2.6 -3.2 39.8 4.01 6.75 5.50

2003 3.8 0.7 19.6 -2.2 -4.7 43.9 4.72 5.25 6.70

2004 5.3 3.6 19.0 -1.5 -3.9 41.9 4.07 6.50 6.20

2005 3.2 2.2 17.7 -1.4 -2.5 42.0 3.86 4.50 5.00

2006(f) 5.8 1.3 14.0 -2.0 -2.4 45.0 3.90 4.00 4.98

2007(f) 2008(f) 5.8 5.4 2.3 2.5 11.0 10.0 -2.4 -2.6 -3.9 -3.5 46.0 46.0 3.75 3.80 4.25 4.50 5.20 5.30

LITHUANIA GDP, % Inflation, average, % Unemployment, % Current account, % of GDP Public sector financial balance, % of GDP Public sector debt, % of GDP EUR/LTL, end of period 3-month interest rate, eop 5-year government bond, eop

POLAND GDP, % Inflation, average, % Unemployment, % Current account, % of GDP Public sector budget balance, % of GDP Public sector debt, % of GDP EUR/PLN, end of period Key rate, eop 5-year government bond, eop

(f) = forecast

24

Key economic data Eastern European Outlook — March 2007

RUSSIA 2001 GDP, % 5.1 Inflation, average, % 21.6 Unemployment, % 9.0 Current account, % of GDP 11.1 Public sector financial balance, % of GDP 2.7 Public sector debt, % of GDP 47.6 USD/RUB, end of period 30.10 3-month interest rate, eop 18.00

2002 4.7 15.8 8.1 8.4 0.6 40.4 31.80 14.50

2003 7.3 13.7 8.6 8.2 1.4 29.6 29.50 6.90

2004 7.2 10.8 8.2 9.9 4.9 22.4 27.70 6.40

2005 6.4 12.7 7.6 10.9 8.1 14.5 28.70 6.50

2006(f) 6.7 9.7 7.2 10.0 7.5 9.0 26.30 5.50

2007(f) 2008(f) 6.5 6.0 8.5 8.0 6.7 6.5 7.0 4.5 4.0 3.0 7.5 7.0 24.50 24.00 6.00 6.50

2002 4.1 3.5 18.7 -8.0 -7.7 43.3 41.50 6.50 5.40

2003 4.2 8.4 17.6 -0.8 -3.7 42.7 41.10 6.00 5.20

2004 5.4 7.5 18.2 -3.5 -3.0 41.6 38.70 4.00 4.00

2005 6.0 2.8 16.3 -8.8 -2.9 34.5 37.80 3.00 3.20

2006(f) 8.3 4.3 13.5 -7.9 -3.4 34.2 34.40 4.75 4.40

2007(f) 2008(f) 8.0 6.5 2.5 2.3 12.2 11.0 -4.5 -3.5 -3.0 -2.8 33.5 33.2 32.00 31.50 4.25 4.00 3.90 3.80

2002 5.2 0.8 9.6 7.5 0.7 33.5 5.33 7.00 7.90

2003 9.6 5.2 9.1 5.8 -0.2 29.0 5.33 7.00 23.50

2004 12.1 9.0 8.6 10.6 -3.2 24.7 5.31 9.00 28.00

2005 2.6 13.5 7.2 3.1 -1.8 17.7 5.05 9.50 15.30

2006(f) 7.0 9.1 5.5 -1.5 -1.0 15.3 5.05 8.50 12.80

2007(f) 2008 (f) 7.5 8.0 8.5 8.0 5.0 4.0 -2.0 -3.0 -1.5 -1.5 14.0 13.0 5.05 5.05 8.50 8.00 10.00 9.50

SLOVAKIA 2001 GDP, % 3.2 Inflation, average, % 7.2 Unemployment, ILO, % 19.3 Current account, % of GDP -8.4 Public sector financial balance, % of GDP -6.5 Public sector debt, % of GDP 49.2 EUR/SKK, end of period 42.70 Key rate, eop 7.75 5-year government bond, eop 7.70

UKRAINE 2001 GDP, % 9.2 Inflation, average, % 12.0 Unemployment, % 10.9 Current account, % of GDP 3.7 Public sector financial balance, % of GDP -0.3 Public sector debt, % of GDP 36.5 USD/UAH, end of period 5.30 Key rate, eop 12.50 3-month interest rate, eop 28.30

(f) = forecast

25

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Are you looking for business opportunities in China, India and Eastern Europe? Make it happen at Globe Forum 2007, the leading event for decision-makers and entrepreneurs. During April 18-20, at Berns and China, Stockholm, more than a thousand Nordic business people will have the chance to meet and create new business opportunities with some 500 counterparts from China, India and Eastern Europe. In 50 workshops, a hundred roundtable seminars and speed meetings, you will get a chance not only to make valuable contacts and discuss areas of mutual interest, but also cut deals that launch enR. Gopalakrishnan, Viktor Gerashchenko, David Tang, Sucheta Dalal, tirely new business partnerships. Executive Director, Chairman of the board, Founder Consulting Editor, Tata & Sons. Yukos. Shanghai Tang. Moneylife. Globe Forum is a unique oppor tunity to meet the right people who can make a difference in forForward thinking in Emerging Markets ging new and mutually beneficial ventures between the Nordic region and emerging markets. To register and find out more about globe forum, visit our site S TO C K H O L M A P R I L 18 –2 0 2 0 07 at www.globeforum.com

GLOBE FORUM