Directional Economics EMEA - ING Think · Directional Economics report showcases ING’s unique macro-economic and strategy footprint across the EMEA region and we encourage you to

November 2018

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12 November 2018

www.ing.com/THINK

Economic & Financial Analysis

Directional Economics EMEA Brexit’s impact on Central Europe: Who and what is most at risk?

EMEA Economics and Strategy Team

Bulgaria

Croatia

Czech Republic

Hungary

Kazakhstan

Poland

Romania

Russia

Serbia

Turkey

Ukraine

**Please note that this is the non-investment research version of Directional Economics EMEA and does

not include the investment strategies contained in the Global Markets Research version of this report**

Directional Economics EMEA November 2018

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Contents

Summary 1 Brexit and Central Europe: Who and what is at risk?.................................................................... 1

Brexit’s impact on Central Europe: Who and what is most at risk? 5 Disruptive trade: Impact on countries and industries .................................................................. 5 Brexit: The end of free movement and remittances ..................................................................10 Money: How will Brexit hit the flow of EU funds? ........................................................................13 Scope for fiscal response – CE4 focus ............................................................................................16

Countries 18 Bulgaria .................................................................................................................................................19 Croatia ...................................................................................................................................................21 Czech Republic .....................................................................................................................................23 Hungary ................................................................................................................................................27 Kazakhstan ...........................................................................................................................................31 Poland....................................................................................................................................................33 Romania ................................................................................................................................................37 Russia ....................................................................................................................................................41 Serbia .....................................................................................................................................................45 Turkey ....................................................................................................................................................47 Ukraine ..................................................................................................................................................51

Disclaimer 53

Chris Turner Global Head of Strategy and Head of EMEA and LATAM Research London +44 20 7767 1610 [email protected]

Rafal Benecki Chief Economist, Poland Warsaw +48 22 820 4696 [email protected]

Ciprian Dascalu Chief Economist, Romania Bucharest +40 31 406 8990 [email protected]

Dmitry Dolgin Chief Economist, Russia and CIS Moscow +7 495 771 7994 [email protected]

Petr Krpata, CFA Chief EMEA FX and IR Strategist London +44 20 7767 6561 [email protected]

Muhammet Mercan Chief Economist, Turkey Istanbul +90 212 329 0751 [email protected]

Jakub Seidler Chief Economist, Czech Republic Prague +420 2 5747 4432 [email protected]

Péter Virovácz Senior Economist, Hungary Budapest +36 1 235 8757 péter.virová[email protected]

With thanks to James Smith Economist, Developed Markets London +44 20 7767 1038 [email protected]

Raoul Leering Head of International Trade Analysis Amsterdam +31 20 563 4407 [email protected] Cover photograph courtesy of shutterstock Publication date 12 November 2018

**Please note that this is the non-investment research version of Directional Economics EMEA and does not include the investment strategies contained in

the Global Markets Research version of this report**


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Summary Brexit and Central Europe: Who and what is at risk? We are now less than six months away from the UK’s departure from the EU. While the implications will be profound for the whole of Europe, Brexit will especially resonate with Central Europe.

Here European supply chains will be questioned and to a lesser extent the free movement of people and its impact on remittances from the UK. Brexit will also draw attention to the 2021-27 EU budget round, where the loss of the UK’s contribution will be painful, but, additionally, the application of new objectives should deliver substantial changes to developmental budgets.

Our main thematic article in this Directional Economics focuses on these core issues. In terms of European supply chains, our trade team together with our CEE economists examine the value-added contributions of European exports coming into the UK. After the Netherlands, it is the Czech Republic, Poland and Hungary with the largest relative exposures to UK demand.

While these exposures are still relatively small in GDP terms, they do centre on a few key industries such as the auto sector, agriculture and textiles, as well as services. The ability to keep these industries within a single market, let alone a customs union remains uncertain and places a heavy burden on the need for a UK transition period into 2020, if not longer.

Poland has the biggest share of its ex-pats working in the UK and sends the largest share of remittances out of the UK. However, Polish workers enjoyed the first wave of EU enlargement in 2004 and look more likely to receive ‘settled status’ in the UK after Brexit. The same may not be true for Romanians, where full access to the labour market was only granted in 2014. That said, remittances from the UK are only a small share of GDP.

The larger implication of Brexit on Central Europe will be what it means for the 2021-27 EU budget. Currently, the UK contributes around 6% of the EU’s budget. The indirect impact could be bigger, however. The UK’s departure will see average GDP per capita levels decline in the EU, depriving some countries of funds as their GDP per capita levels rise above the new EU average. This could impact the Czech Republic, Poland and Bulgaria.

In spite of Brexit, we expect growth in Central Europe to soften rather than slow sharply from the above-trend readings posted earlier this year. That should allow the Czech Republic and Romania to continue in their tightening cycles and Hungary to start. Despite growing market expectations, we doubt a Polish MPC tightening cycle will get off the ground in 2019 – and probably not in 2020 either.

Away from the CE4, sharply higher interest rates and leading indicators suggest Turkey’s growth rate will slow sharply over coming quarters. The slowdown in domestic demand will certainly help narrow Turkey’s external imbalances, but the persistence of inflation means the TRY will struggle to deliver more of a recovery in nominal terms.

We expect Russian growth to continue to run at meagre levels, constrained by external uncertainties and tight fiscal policy. Unless the government is successful in reigniting full-scale investment growth, its budget policy framework may prove unsustainable.

As always, the Directional Economics report showcases ING’s unique macro-economic and strategy footprint across the EMEA region and we encourage you to stress-test our 2019 views.

Chris Turner, Global Head of Strategy and Head of EMEA and LATAM Research London +44 20 7767 1610


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Country summaries: CE4

Czech Republic Hungary Czech GDP growth slowed to 3.3% in 1H18, after 4.5% growth in 2017. While last year’s growth was based on all parts of demand, this year growth is mostly driven by domestic demand, particularly household consumption and investments. Net exports are contributing negatively and imports are growing due to import-intensive investments. Exports have slowed on slightly weaker foreign demand and limited producer capacity. The overheated labour market is pushing wages up, contributing to solid household consumption and mounting inflationary pressures. The CNB wants to move interest rates from the zero-bound. Five hikes were delivered this year, and with the outlook for a more slowly appreciating CZK less sensitive to the interest rate differential, more hikes are likely next year.

Real GDP increased by 4.7% YoY in 1H18, the best reading since 2004. However, based on our LeadING HUBE indicators, we think economic activity has peaked. The seasonally and calendar-adjusted data also suggest that the economy is heading towards a more moderate growth path. Regarding 2018 as a whole, we expect 4.3% YoY GDP growth. The fiscal stance is in line with the government’s plan or is even better. In view of the underlying factors, the 2.4% deficit target is not in jeopardy. Looking forward to 2019, the NBH will be in the limelight. Inflation has started to accelerate, pointing to an above 3% YoY average reading for next year. Core inflation is still below the 3% target, but could suddenly change. We expect the NBH to start policy normalisation in 2H19.

Poland Romania A second surprise in a row, with lower fiscal deficit and limited external vulnerability, secures Poland’s position as a stable bay among EMs. In tandem with higher hike expectations, this improved data calls for PLN resilience to negative EM sentiment. We look for €/PLN close to 4.30 in 4Q18. POLGBs may slightly underperform core markets in 2019. Of PLN20bn foreign-held bonds maturing next year some PLN10bn are unlikely to be reinvested, as POLGBs seem expensive. Moreover, new debt issuance in 2019 is slightly higher than in 2018 (PLN41bn vs PLN38bn). External factors are a risk as well (EM tensions caused by the Fed, a strong US$ and Trump extending his protectionist policy). 2019 is election year, but we believe 2020 could be burdened with any spending pledges.

Three consecutive years of 3.0% of GDP budget shortfall, despite a strong GDP growth backdrop and accommodative monetary policy stance, led to twin deficits flashing red on investors’ radar. The NBR reaction was adequate, though a bit tardy, but tighter monetary policy stance is unlikely to be the panacea for bringing the economy back on track. With a heavy election calendar ahead, fiscal consolidation is doubtful. Risks to structural reforms are tilted to a rollback rather than acceleration. Absent an external shock, growth is likely to be supported by external demand, though limited by structural issues. The inflation outlook should stay skewed to the upside and external imbalances mostly likely will continue to widen. All in all, not an imminent disaster but vulnerable to any surprises.

Country summaries: Other Central & Eastern Europe

Bulgaria Croatia The economy is enjoying the best post-global financial crisis moments, but the convergence pace is slower than before the crisis. This is mainly due to lower potential GDP growth despite a pickup in productivity as the country is almost running out of labour resources and capital accumulation is sluggish. A pickup in investments, supported by EU funds, is likely to upgrade potential growth, but higher wages are failing to increase employment due to negative demographic trends. The ERM-II bid initially disappointed the government. An agreement has subsequently been reached on next steps ahead of entering the euro adoption waiting room expected in mid-2019, simultaneously with banking union. In the meantime, the CPI trajectory confirmed the ECB’s sustainability concerns.

With two outlook upgrades this year, from S&P and Fitch, the prospect of earning an investment grade rating within the next couple of years looks within reach. Moreover, the country intends to, and has real prospects of, joining the ERM II in 2020, though adopting the euro by 2022 is a different story. Solid domestic demand and another record year in tourism supported robust economic growth while fiscal consolidation continued and a phased tax reform was enacted. This partially addresses the increasingly worrying labour market shortage. The window of opportunity to step up reform could soon be closing though, as the next three years are marked by presidential, parliamentary and local elections, in a country traditionally prone to political instability.

Serbia Turkey The Serbian economy is enjoying the benefits of past reforms and prospects of EU membership, with investment boosting growth, capital inflows supporting the RSD and core inflation tamed, allowing the central bank to lower borrowing costs. The 30 month precautionary deal with the IMF agreed in June 2018 seems effective, with the IMF last citing “dramatic improvements in the last few years”. This will allow the government to abolish the pension cuts from 2014 while also relaxing labour taxation. A bold increase in capital spending is also planned for next year for which a -0.5% of GDP budget deficit has already been agreed with the IMF, following two consecutive years of fiscal surpluses.

A less supportive global backdrop together with USD strength, geopolitical issues (deteriorating Turkey-US relations) and macro imbalances have been factors that have shifted the focus to Turkey, with significant volatility in domestic financial markets in 2018. Following the August developments, concerns about the economy’s large FX debt service have risen as overall external financing needs have increased. Given this backdrop and after the September rate adjustment by the CBT, implementation of the government’s action plan and likely steps for the banking sector are key for stabilization of domestic financial markets. The MTP provides a prudent fiscal stance, which will support the already sharply tightened monetary policy to rebalance the economy to a more sustainable path.


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Country summaries: CIS

Russia Kazakhstan With elections and the football World Cup behind, Russia is struggling to regain growth momentum, which is a challenging task amid uncertainties with global trade and mounting foreign policy tensions. The monetary policy has to remain moderately tight mid-term amid accelerating CPI, and the budget policy remains focused on state savings accumulation – yet it might have to be eased eventually. Local FX and FI should be following the global portfolio flows, suggesting a mildly positive outlook, yet subject to downside risks. The potential introduction of sanctions against the new Russian state debt is not yet priced into asset prices and poses a downside risk to our FX/FI outlook. However, we do not see Russia’s financial stability to be at any material risk.

We have a constructive view on the GDP growth story that, unlike the country’s financial flows, is diversified away from oil. We welcome the government’s efforts to build fiscal buffers, which should reinforce the perception of the country risk. For now, we concur with consensus expecting stabilisation of FX and CPI. Yet, the still high dependence of financial flows on the volatile external variables, such as oil price, state of global trade and EM portfolio inflows, remain a risk factor. A lack of clarity on the political succession in 2020 alongside the country’s recovering but still weak banking sector will remain key local factors of uncertainty on the key indicators, mainly fiscal. As with Russia and China, Kazakhstan’s trade partners, risks to our forecasts are skewed to the downside.

Ukraine 2018 growth momentum is likely to continue next year, but slower, with domestic demand still growing on rises in minimum wages and pensions and remittances to Ukraine. Some downside risks stem from higher CPI dynamics, tighter monetary policy, and the tight fiscal policy required by the IMF. Recent agreement with the IMF seems to be positive for sentiment ahead of FX debt redemption and servicing (US$8.3bn) in 2019. Approval of the IMF-compliant budget for 2019 might be tense, with proposed tax changes and elections due in Mar/Oct-19. We assume the first tranche to be disbursed to Ukraine by end-2018/early-2019. Together with EU/World Bank funds, this should boost Ukraine’s FX reserves to US$20bn. Political uncertainty on 2019-elections remains.


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ING main macroeconomic and financial forecasts

Real GDP (% YoY) Exchange rate (quarterly is eop, annual is avg)

3Q18F 4Q18F 1Q19F 2Q19F 2018F 2019F 3Q18F 4Q18F 1Q19F 2Q19F 2018F 2019F

Bulgaria 3.0 3.7 3.3 3.0 3.3 3.5 EUR/BGN 1.96 1.96 1.96 1.96 1.96 1.96 Croatia 2.5 2.4 2.3 2.5 2.6 2.5 EUR/HRK 6.48 6.32 6.13 5.92 6.33 5.90 Czech Republic 2.7 2.7 2.9 2.9 3.0 2.9 EUR/CZK 25.77 26.00 25.70 25.60 25.65 25.58 Hungary 4.3 3.7 3.5 3.5 4.3 3.3 EUR/HUF 323.4 325.0 325.0 320.0 320.2 319.0 Kazakhstan 3.8 3.5 3.2 3.4 3.9 3.5 USD/KZT 363 350 340 350 341 354 Poland 4.9 4.2 3.9 3.5 4.8 3.5 EUR/PLN 4.27 4.30 4.24 4.25 4.26 4.27 Romania 3.2 3.9 4.8 3.9 3.8 4.0 EUR/RON 4.66 4.70 4.67 4.70 4.66 4.71 Russia 1.3 1.7 1.1 0.8 1.6 1.0 USD/RUB 65.6 63.0 64.0 65.0 62.2 64.6 Serbia 3.7 4.5 3.9 3.5 4.5 3.7 EUR/RSD 118.3 118.5 118.0 117.5 118.20 117.50 Turkey 3.3 -1.4 -3.5 -1.1 3.3 0.3 USD/TRY 6.06 5.80 6.03 6.26 4.94 6.31 Ukraine 2.7 2.6 2.2 2.7 3.1 2.9 USD/UAH 28.24 30.00 29.50 30.00 27.79 29.90 Eurozone 1.7 1.3 1.3 1.2 1.9 1.4 US 3.0 3.2 3.0 2.5 2.9 2.4 EUR/USD 1.15 1.15 1.15 1.18 1.17 1.20

*% QoQ annualised Source: National sources, Bloomberg, ING estimates

Source: National sources, Bloomberg, ING estimates

CPI (% YoY, quarterly is eop except for US/EZ avg, annual is avg) Central Bank rate (%, eop)


Bulgaria 3.6 3.0 3.3 3.3 2.8 3.3 Bulgaria 0.00 0.00 0.00 0.00 0.00 0.15 Croatia 1.4 1.7 2.0 1.8 1.8 1.9 Croatia 0.30 0.30 0.30 0.30 0.30 0.40 Czech Republic 2.3 2.4 2.9 2.3 2.2 2.6 Czech Republic 1.50 1.75 2.00 2.25 1.75 2.50 Hungary 3.6 3.6 3.5 3.4 3.0 3.4 Hungary 0.90 0.90 0.90 0.90 0.90 0.90 Kazakhstan 6.1 6.0 6.5 6.5 6.3 6.3 Kazakhstan 9.00 9.25 9.25 9.25 9.25 8.00 Poland 1.9 1.7 2.8 3.0 1.7 2.7 Poland 1.50 1.50 1.50 1.50 1.50 1.50 Romania 5.0 3.9 3.7 3.5 4.7 3.6 Romania 2.50 2.50 2.75 3.00 2.50 3.25 Russia 3.4 4.0 5.2 5.7 2.9 5.3 Russia 7.50 7.50 7.50 7.50 7.50 7.50 Serbia 2.1 2.8 3.0 3.0 2.3 2.8 Serbia 3.00 3.00 3.00 3.00 3.00 3.25 Turkey 24.5 25.7 25.6 21.9 17.2 20.9 Turkey 24.00 24.00 26.00 24.00 24.00 21.00 Ukraine 8.9 9.5 8.3 8.1 10.9 8.1 Ukraine 18.00 18.00 18.00 18.00 18.00 16.00 Eurozone 2.0 1.9 1.8 1.7 1.7 1.7 Eurozone 0.00 0.00 0.00 0.00 0.00 0.00 US 2.6 2.5 2.4 2.6 2.5 2.5 US 2.00 2.25 2.50 2.75 2.50 3.00

Source: National sources, Bloomberg, ING estimates Source: Bloomberg, ING estimates

10yr local yield (%, quarterly is eop, annual is avg) 3m local rate (%, quarterly is eop, annual is avg)


Bulgaria 1.04 1.04 1.14 1.24 1.08 1.25 Bulgaria -0.05 -0.05 -0.05 0.00 -0.02 0.05 Croatia 2.20 2.40 2.40 2.50 2.25 2.50 Croatia 0.50 0.50 0.55 0.55 0.50 0.63 Czech Republic 2.19 2.20 2.30 2.40 2.05 2.35 Czech Republic 1.70 1.95 2.20 2.45 1.26 2.42 Hungary 3.55 3.65 3.65 3.75 3.1 3.8 Hungary 0.17 0.16 0.20 0.30 0.13 0.43 Kazakhstan n/a n/a n/a n/a n/a n/a Kazakhstan 10.00 10.25 10.25 10.25 10.40 10.00 Poland 3.24 3.20 3.23 3.26 3.24 3.26 Poland 1.72 1.73 1.73 1.73 1.71 1.73 Romania 4.77 5.10 5.20 5.30 4.89 5.30 Romania 3.17 3.20 3.40 3.60 2.90 3.61 Russia 8.5 8.5 8.3 8.1 7.9 8.1 Russia 8.1 8.3 8.1 7.9 7.7 7.9 Serbia 4.60 4.60 4.60 4.60 4.75 4.65 Serbia 2.92 3.00 3.00 3.00 2.93 3.06 Turkey 17.92 19.80 19.95 17.47 16.36 17.37 Turkey 27.31 27.70 27.93 24.63 20.22 24.52 Ukraine n/a n/a n/a n/a n/a n/a Ukraine n/a n/a n/a n/a n/a n/a Eurozone 0.40 0.50 0.50 0.50 0.43 0.55 Eurozone -0.33 -0.32 -0.32 -0.32 -0.33 -0.24 US 3.00 3.20 3.30 3.20 3.05 3.23 US 2.45 2.64 2.95 3.26 2.44 3.27

Source: National sources, Bloomberg, ING estimates Source: National sources, Bloomberg, ING estimates


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Brexit’s impact on Central Europe: Who and what is most at risk? • Brexit will be will be disruptive and divisive for the whole of the European Union. In

this article, we focus on its impact on Central and Eastern Europe (CEE) through three key channels: trade, free movement and money.

• In terms of trade, we look at value added exports to the UK as these better reflect what the CEE actually contributes to European supply chains. While these exports are low in terms of GDP, the Czech Republic, Poland and Hungary look the most exposed in the region.

• Agriculture, autos, textiles and retail trade are the sectors dominant in CEE trade with the UK. Regulatory and logistical barriers pose challenges here.

• Free movement has seen Czech, Hungarian and Polish workers gain a ten-year headstart on the Romanians in entering the UK. Around a quarter of Poles working abroad live in the UK. Having a more mature presence in the UK should mean the early movers are more likely to receive ‘settled status’.

• On the money side, the UK had been funding around 6% of the EU’s budget. This contribution will disappear for the 2021-27 round. However, the indirect impact of the UK’s departure may be larger. The EU average GDP per capita level will drop after Brexit, propelling the likes of the Czech Republic and Poland above key financial thresholds. EU funding for CE4 economies could drop by anywhere between 12% and 24% in real terms.

Introduction As the clock counts down to the UK’s formal exit from the European Union, fears are growing that Britain may leave without a deal. Lawmakers in the UK are deeply divided on the form that Brexit should take, and there is a growing perception that Parliament could reject the final withdrawal agreement. For now, that’s not our base case, but either way we may not know for sure until much closer to the UK’s exit date next March.

But even if a deal is reached and approved, it could still be many months or even years before we know for sure what the final trading relationship will look like. This will be negotiated during the 21-month transition period, and the form that this will take is still uncertain. All of this means that firms are increasingly having to take a careful look at what Brexit might mean for their operations, and the risks differ across different industries and countries.

In this article, we will look at Brexit’s impact on Central and Eastern Europe (CEE) through a variety of channels, such as: (1) the disruption to trade; (2) what Brexit means for the free movement of people and remittances from the UK; and (3) the loss of the UK’s contribution to the EU budget.

Disruptive trade: Impact on countries and industries There are many ways to look at the Brexit impact on trade with CEE and, of course, many assumptions to be made. Should we just be looking at the impact of a slowdown in the UK – the primary channel – or the impact of a disorderly Brexit that leads to a sharper slowdown in the European Union – the secondary channel?

For example, as one of the most open economies in the region, Hungary perhaps has a lot to lose. Here gross export volumes are nearly 90% of GDP. For reference, Hungarian authorities believe Brexit could lower Hungary’s GDP by 0.2% on average until the end of

Fears are growing that Britain may leave without a deal

As one of the most open economies in the region, Hungary perhaps has a lot to lose


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2020 if the Brexit impact were localised to the UK. But GDP would be 0.5% lower were Brexit to cause a technical recession in the EU.

Rather than merely looking at gross export exposures of Eastern Europe to the UK, in this article we use the World Input Output database (WIODD) to measure CEE’s exports in value added terms. This gauge of exports is more in line with today's economic reality – characterised by many cross border supply chains. This value added data also provides insights into key sectors impacted.

Gross exports versus value added exports By linking national accounts of more than 50 countries, the WIODD method leads to cross border matrices showing where inputs used in production are coming from and where the (intermediate or final) output is going.

This value added method avoids the double counting of exports that occurs using the traditional method of gross exports. The latter method adds the full value of an exported product to the overall exports of that country, although part of this value is to be attributed to the countries that supplied imported inputs for fabricating this product.

So using gross exports leads to double counting because these inputs are already booked as exports from the countries that supplied these inputs. Simple!

Figure 1 looks at the role UK demand has on the GDP of twelve selected countries. A traditional gauge of gross export figures shows that the Netherlands is most dependent on the UK – demand, followed by Hungary and the Czech Republic.

Fig 1 Economic dependency on the UK (% of local GDP)

Source: ING, WIODD

But as noted above, gross export figures are not the best way to measure the economic dependency of a country on demand for its products from another, because gross export figures don’t take into account that not all of an export product is produced domestically. For example, in the British auto industry only around 40% of the parts in a UK car are domestically produced.

Value added data of exports can measure more precisely the dependency of each economy on British demand by allocating to each country their share in the production of the final product as consumed in the UK.

Looking at the value added of exports to the UK of the twelve selected countries, the Netherlands still leads the pack. Dutch GDP depends for 3.44% on British demand, 1.5 times as high as the EU average. Hungary drops from second place to fourth spot in the rankings. Spain also drops two places, but most countries’ positions are stable.

0%

1%

2%

3%

4%

5%

6%

Gross exports to the UK (% of GDP) Value Added exports to the UK (% of GDP)

Value added data of exports can measure more precisely the dependency of each economy on British demand


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Poland still emerges as relatively exposed, which should not be a surprise. The UK is Poland’s second largest export market and Poland maintains a large trade surplus with the UK worth just over €8bn per annum.

Goods and services: Which sectors are most at risk? The WIODD data provides insights into which sectors could be most at risk from Brexit. With data for up to 55 industry sub-sectors per country, there’s clearly risk of data overload here. Of the many ways to present the trade linkages, in Figure 2 we’ve chosen to highlight the relative exposure of EMEA employment to the Brexit story. This diagram nicely shows a consistent set of sectors across the region that could be impacted.

We’ll now look at Brexit from both a goods and services perspective.

Fig 2 How EMEA jobs are tied to trade with the UK

Source: ING, WIODD

Poland2.0%

1.1%Romania

0.4%Russia

1.1%Turkey

1.3%Bulgaria

Czech Rep2.1%

Hungary1.8%

Crop &animal Prod.

Crop &animal Prod.

Retail trade

Admin & support

Crop &animal Prod.

Textiles

Textiles

Crop &animal Prod.

Motor vehicles

Fabricated metal

Crop &animal Prod.

Admin & support

Motor vehicles

Retail trade

Retail trade

Wholesale trade

Land transport

(Percentage of country’s total employment related to value added exports to the UK)

Motor vehicles

Wholesale Trade

Retail trade

Retail trade

Wholesale Trade

Land transport

Machinery

Computers

FoodLand

transport

Wholesale Trade

Textiles

Poland still emerges as relatively exposed, which should not be a surprise


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Trade in goods: Border frictions create risks for supply chains One way or another, there is a clear risk of greater supply chain friction after Brexit.

If the UK leaves the EU without a deal in March, Britain will automatically begin trading on World Trade Organization (WTO) terms. But even if an agreement is reached and approved in time to avoid this costly scenario, there is still a possibility that the UK chooses to take the “Canada-plus” route, and negotiate a free trade agreement with Europe over coming years. This would come into effect after the transition period, which is currently billed to last until December 2020 (although in reality, this will probably need to be extended).

In either case, the UK would not enjoy the same level of access to the EU customs union or single market that it does today. Outside of the customs union, goods would be subject to tariffs and complicated rules of origin requirements. By leaving the single market for goods, the EU would no longer recognise UK rules and regulations and would require items to be checked upon entry.

This would inevitably place extra burden on firms, many of which currently trade exclusively within the EU and are therefore not used to much of the extra bureaucracy that would be created. Given that much of the infrastructure and staffing requirements are not yet in place at many of the UK’s ports, these new processes risk creating significant delays and tailbacks at the major ports in the UK and Northern Europe.

Fig 3 How Brexit may increase border frictions

Source: ING

All of this risks creating havoc for modern-day supply chains, many of which rely on components from a multitude of suppliers, passing back-and-forth across borders several times during production. As Airbus recently warned, any single failure within the supply chain has the potential to have significant knock-on effects for overall production – particularly given that many companies operate ‘just in time’ production with very limited inventory buffers.

This is a particular concern for car manufacturers, many of which have operations in the CEE. Both Hungary and the Czech Republic are particularly exposed to UK demand for vehicles, with 0.2% and 0.3% of GDP linked to value added exports to the UK, respectively.

Single market

Rules of origin

Rules of origin Tariffs EU Standards VAT Payment Transport rulesRemoves the need for tariff paperwork/payment

Complex requirements don’t apply for goods covered by customs union

Outside of the single market, goods would need to be checked against EU standards Outside of the EU VAT

area, officials would need to check paperwork and the shipment to check all tax is paid

The UK wants to leave the single market for goods/services

Under its current plans, the UK is likely to leave the EU VAT area

Driver/lorry licence rules may differ outside of the single market

Without an agreement, there may need to be a lorry/driver change at the border

Customs union

The transition period is currently billed to last until December 2020

In either case, the UK would not enjoy the same level of access to the EU customs union or single market that it does today

Brexit risks creating havoc for modern-day supply chains

The supply chain is a particular concern for car manufacturers

https://www.airbus.com/content/dam/channel-specific/website-/company/global-presence/uk/Brexit-Risk-Assessment-21-Jun-FINAL.pdf


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The auto sector is the crown jewel of the Hungarian export sector and friction with the UK would hurt. However, local policymakers would expect EU demand to take up the slack – just as it did when exports of agricultural and pharmaceutical goods to Russia were hit following Ukraine-related sanctions.

While Czech exports to the UK represented only 5% of total exports in 2017, the concentration in motor vehicles is more important – with the UK representing around 7% of total Czech car exports. This makes the UK the second biggest car export destination after Germany (CZK65bn of exports compared to CZK291bn to Germany.)

Electrical, machinery and transport equipment comprise around 50% of Romanian exports to the UK. In total these industries employ around 400,000. However, most of the production in this sector is integrated with the global value chain, perhaps mitigating the negative impact of Brexit.

But the sector that arguably faces the biggest challenge is agriculture & food, particularly in the case of a ‘no deal’ Brexit. Food products, particularly meat-based, are typically among the most heavily scrutinised items at borders. Neither Dover nor Calais, both major entry/exit ports for UK-EU trade, have the necessary veterinary inspection points needed to carry out these checks, risking long delays if there is no deal by March.

In the longer run, measures would likely be taken to make checks less onerous or less frequent but, even so, frictions would still be higher than today. Across the countries considered here, 170,000 jobs in Eastern European farming, fishing and food manufacture, are directly exposed to UK export demand.

Polish agricultural & processed food exports to the UK amount to approximately €1.4bn annually (12% of overall exports to the UK). The dominant commodities are chocolate (€27bn), meat products (€27bn) and vegetables (€25bn). Trade in the two latter groups largely hinges on fast delivery and may be affected by border controls. Still, in terms of value added in Poland’s GDP, agriculture exports to the UK are at the EU average and below the CEE average.

In terms of textiles, Turkey and Romania stand out. Textiles represent 20% of Romanian exports to the UK, and this labour intensive industry employs a total of 375,000.

After automotive, textiles & apparel is the most export oriented industry in Turkey having a 16.9% share in the total, while the UK is a major export destination for the sector - 8.8% of its exports are directed to this country. The industry also employs close to 1 million, representing more than 6% of the employment in Turkey as of 2017.

Given the scale of all this potential disruption, over the past few months the UK government has become more open to remaining in something that closely resembles the customs union and single market for goods in the future trading relationship.

Trade in services: A big unknown in the Brexit debate While the government’s most recent blueprint for trade – the so-called Chequers plan – aims to reduce friction for goods, access for services looks like it could be more limited.

For instance, as we’ll go onto discuss later, there is little clarity at this point on what the UK’s future migration policy will look like. Given that services are heavily reliant on people as input, being able to have staff flow quickly and easily across borders is often key. While free movement will continue during the transition period (until December 2020), a ‘no deal’ scenario would likely see a sudden increase in entry barriers and would cast uncertainty over the future residency of EU citizens living in the UK.

Brexit may also challenge some of the Business Process Outsourcing and Shared Services direct investment into the CEE region – a topic we discussed in our last Directional Economics report: Ready, Aim, Invest, 27 March 2018.

The sector that arguably faces the biggest challenge is agriculture & food

Access for services looks like it could be more limited


10

But even though the service sectors of Central European economies may be less exposed to UK demand in some cases, trade in goods and services is increasingly intertwined. For instance, car manufacturers – an important industry across the EMEA region - will rely on design, legal, financial and logistical services to name just a few.

Where these are supplied by UK-based firms, wider supply chains could be impacted if there is a sudden loss of market access. Among other things, a more disruptive Brexit would have serious implications for data sharing and financial services access.

Poland is highly exposed to Brexit in terms of services’ exports to the UK – for example, it has the second largest share in the EU of transport services to the UK (0.6% of GDP) and construction (0.1% of GDP). Polish exports in those categories hinge on overall UK-EU trade and access of foreign workers to the UK labour market. On the other hand, Brexit supports the transition of shared services centres to Poland.

Hungary’s services exports to the UK are twice as large as those for manufacturing. Telecoms, scientific activities, air transportation and support services all feature here. On the employment side, shared service centres look most exposed to the Brexit story.

Brexit: The end of free movement and remittances Bringing free movement to an end has always been at the heart of the Brexit movement, but two years on from the vote, it’s still not clear exactly how this will translate into the UK’s future immigration policy.

That said, for those that are already living or working in the UK, nothing should really change – assuming the withdrawal agreement is settled and ratified. Individuals that have lived in the UK for five years will received “settled status”, allowing them to continue living in the UK indefinitely.

However, this could be thrown into doubt if there is ‘no deal’. While in reality, we suspect a mutual agreement would be quickly reached for existing residents, there would likely be much greater restrictions on new immigration. In any case, the economic disruption that would occur in a ‘no deal’ scenario, including a likely spike in unemployment and a further fall in the pound, would make the UK much less attract to migrants relative to other parts of Europe.

According to World Bank estimates the UK is the fourth largest remittance-sending nation in the world. In 2017 alone, migrant workers sent home US$26.8bn, of which approximately US$9bn was sent to European Union countries.

In 2017, according to Eurostat Balance of Payment data, within the CEE space Poland is the largest recipient of remittances from the EU with total inflows of just over €2.6bn, closely followed by Romania with €2.5bn. Bulgaria, Czech Republic and Hungary are all quite far behind at €0.8bn, €0.7bn and respectively €0.7bn.

The importance of remittances to CEE countries has declined over time. This is because of the increase in nominal GDP and foreign trade integration for the CEE countries, supported by faster convergence and as workers abroad relocated their families after them. Relative to the country’s GDP, total remittances from abroad are more significant for Bulgaria at 1.6% of GDP, followed by Romania at 1.2% and Poland a distant third at 0.6% of GDP. Remittances inflows are just over 0.5% of GDP for Hungary and 0.3% for the Czech Republic.

In terms of remittances from the UK alone, within the CEE space Poland is the largest recipient with total inflows of €1.0bn. Romania, Hungary, the Czech Republic and Bulgaria are all quite far behind at €0.3bn, €0.15bn, €0.14bn and €0.07bn, respectively (based on 2016 data according to Eurostat, as shown in Figure 4).

In 2017 alone, migrant workers sent home US$26.8 billion from the UK

A more disruptive Brexit could have serious implications for data sharing and financial services access

http://www.worldbank.org/en/topic/migrationremittancesdiasporaissues/brief/migration-remittances-data


11

Fig 4 Personal remittance flows within the EU (2016)

Source: Eurostat (Balance of Payments data)

Turning to the particular case of the UK, the historical context has shaped things slightly differently. The two distinct waves of EU enlargement (in 2004 for Poland, Hungary and the Czech Republic and in 2007 for Romania and Bulgaria) have had an important impact on the timing of migrant worker flows.

While for the first wave countries, the UK immediately gave access to its labour market to workers, in the case of Romania and Bulgaria, full access to the labour market was only granted in 2014.

The effects of this decision are mostly visible in Poland’s case, as almost 25% of Polish citizens that migrated abroad are living in the UK and the funds they send back to Poland represent a third of all remittances from abroad. Of the Hungarian migrants just over 14% live in the UK and send back home almost a quarter of all remittances inflows.

Catching up rapidly over recent years has been Romania, whose migrants managed in just a few years after 2014 to become the second largest non-UK nationality. As of 2017, they comprise 11% of the total Romanians living abroad and are sending home 13% of total remittances.

Fig 5 UK market important for CEE workers… Fig 6 …but remittances less important for home countries

Bubble size = country population Source: Eurostat

Bubble size = country population Source: Eurostat

€1,031(34% of Poland total)

€155(23% of Hungary total)

€66(8% of Bulgaria total)€140(22% of Czech total)

€99(3% of Serbia total)

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€35(3% of Croatia total)

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25% of all Polish citizens that migrated abroad are living in the UK


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The remittance channel is less important for the home countries both in terms of size and as a source of external financing, especially as CEE economies (except Romania) are posting balanced or surplus current accounts.

The next question that comes to mind is what’s going to happen to CEE workers in the UK? In any Brexit scenario, it is hard to imagine that so many workers could be replaced in such a short period of time. Even in a more phased-in approach, workers from the first wave (most notably Polish) mostly have over five years of UK residency and are likely to stay on.

On the other hand, CEE economies are generally facing labour market shortages, a problem without short-term fixes, except maybe for Poland and the influx of Ukrainian workers. The return of the citizens working abroad could alleviate the labour market problems, but it remains a remote possibility due to the still relatively large pay gap.

Even for latecomers to the UK labour market, such as Romanians, in a negative Brexit scenario, we see it more likely that they look for job alternatives in other Western Europe countries. Hence, patience and structural reforms will remain key to solving CEE labour shortages.

Migration is an important issue for CEE countries as they are projected to suffer among the worst losses in terms of population over the next half century with negative implications for potential GDP growth and rising old-age dependency ratios.

Fig 7 Projected population change, 2016-2080 (%)

Source: Eurostat

- 50- 40- 30- 20- 10

0 10 20 30 40 50 60 70 80 90

What’s going to happen to CEE workers in the UK?

CEE economies are generally facing labour market shortages

CEE countries are projected to suffer among the worst losses in terms of population over the next half century


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Money: How will Brexit hit the flow of EU funds? The UK has been providing about 6% of the entire EU budget The UK’s departure from the EU also opens a question on the inflow of EU funds into the CEE space due to the UK’s missing net contribution to the EU budget.

As the amount paid into the EU budget should, in principle, be similar for each member state based on its Gross National Income (GNI), the departure of the UK – being the second/third largest EU economy after Germany and France – should in theory have a significant impact on the EU budget.

However, due to the rebate system introduced in 1980s, the UK’s contribution to the EU has been lower than its GNI would suggest. Indeed, LSE (2016) shows that the UK has always paid significantly less than France since 1985, a similar size economy.

Based on the various calculations, the UK’s net contribution to the EU budget should be around €10bn per year. Though the gross contribution of the UK is almost twice as high, rebates are worth some 30% and also there are some other budgetary flows returning to the UK. As such, the UK’s net contribution represented around 6% of the total EU budget in the 2014-20 multiannual financial framework (MFF), while the UK’s share of GNI to total EU28 was around 15% in that period.

The 2014-20 budgetary period and a ‘No Deal’ Brexit Assuming the UK’s withdrawal agreement is agreed and approved, Britain will honour its budget commitments throughout the transition period lasting until December 2020, so the current 2014-20 financial framework shouldn’t be affected. If there is a ‘no deal’ Brexit, then that would be thrown into doubt, although we think it likely an emergency agreement would be reached to ensure the gap is covered.

But taking into account the UK’s contribution to the EU and the fact that broadly 40% of the EU budget goes to structural and investment funds (€400bn) in the 2014-20 MFF, the total outage from “no-deal Brexit” in 2019-20 as a worst case scenario could be around 2% of the total EU budget inflow for a particular member state (data provided in Figure 9, columns 1-2). But given the complications stemming from a “no deal”, we do not consider this a very likely scenario.

New 2021-27 EU budget is driven by new priorities, not only a lower UK contribution Having said that, the departure of the UK will impact the new financial perspective 2021-27. Based on the abovementioned UK contribution to the EU budget, the impact should be around 6%, so the total budget in nominal terms following Brexit would drop to €1,279bn, versus the €1,360bn that would be available if Brexit were to be avoided.

It’s worth noting that if the post-Brexit transition period is extended beyond 2020 – as we believe likely – then this would likely see the UK continuing to make contributions to the 2021-27 budget during this time.

Either way, some cuts in the new MFF EU budget have been introduced, eg, in the Common Agricultural Policy (CAP) and some structural funds. Yet these changes were motivated mainly by new priorities for the 2021-27 period (border defence, security, environmental changes or digital economy) rather than a lower EU budget itself.

Brexit will see average GDP EU per capita decline, which will have some implications Perhaps the biggest impact of Brexit on EU fund distribution will be the indirect impact it has on average EU per capita income. Brexit means that the average EU per capita income will decline, meaning that some CEE regions will newly cross above the 75% of GDP per capita of the EU average. This will make them less eligible for EU funds.

The UK’s net contribution represented around 6% of the total EU budget in the 2014-20 framework period

The total outage from “no-deal Brexit” in 2019-20 as a worst case scenario could be worth around 2% of the total EU budget

Brexit means that the average EU per capita income will decline…

https://eprints.lse.ac.uk/67030/1/Begg_EU%20budget.pdf


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Regions below the 75% GDP per capita EU average are considered “less developed”, while those in the range of 75-100% are considered to be in transition. Looking at the new regional eligibility map (Figure 8), some regions in the CEE space will no longer be eligible for payments from the ERDF (European regional development fund) or ESF (European social fund) due to crossing the threshold. Compared to the prior budget round, we think the Czech Republic will be most affected, followed by Poland and Bulgaria.

Fig 8 Regional eligibility map, 2021–27

The outermost region of Saint-Martin is included in the NUTS2 Guadeloupe region Source: European Commission

New criteria might redirect EU funds from the CEE space to other regions Last but not least, a lower contribution for some CEE countries might be caused by a new set of criteria planned for introduction in the new MFF 2021-27.

Here it is not only GDP per capita (which still has the most important weight of 81% in the criteria), but also the youth unemployment rate, the low education level (15% weight), climate change (1%) and/or migrant integration (3%) that are relevant. This might redirect some EU money flow to other southern EU regions instead of the CEE.

Taking into account the abovementioned criteria and the expected GDP per capita thresholds for the EU countries, the EU Commission has introduced estimates of the possible distribution of the EU budget for particular member states in the new 2021-27 MFF (Figure 9, columns 5-6).

…meaning that some countries will cross above the 75% threshold and become less eligible for EU funds


15

Fig 9 Proposal of new funds allocation

"No deal gap"

2019-2020 GDP

2017 2014-20

Period 2021-27 Proposal

Nominal euro decline

Real euro decline

Share of total fund payments (%)

Column: 1 2 3 4 5 6 7 8 9 €bn % of GDP €bn €bn €bn (%) (%) 2014-20 2021-27

Bulgaria* 0.2 0.4 50 9.9 10.1 2.1 -8.6 2.5 2.7 Cyprus 0 0.1 19 0.9 1 7.3 -3.7 0.2 0.3 Czech R.** 0.5 0.3 192 23.9 20.1 -15.7 -24.4 6 5.4 Croatia 0.2 0.4 49 10.7 9.9 -7.8 -17.3 2.7 2.7 Hungary** 0.5 0.4 123 25.0 20.2 -19.1 -27.5 6.3 5.4 Poland** 1.8 0.5 370 86.1 72.7 -15.5 -24.4 21.6 19.6 Romania* 0.6 0.3 188 30.9 30.8 -0.4 -10.9 7.7 8.3

*EC estimates an 8% increase of funds at 2018-constant prices for those countries; **To avoid too strong a decline in EU funds contribution, the EC included a 24% decline limit as a “safety net”, see European Com. Panorama 2018/No. 65 Source: EC COM(2018) 375 fina, https://cohesiondata.ec.europa.eu/, ING

Notably the figures in columns 4-5 and the decline in column 6 are in current prices, meaning that its “real change” might be greater due to inflation during the period ahead.

Using 2% inflation over the seven-year period, which is assumed by the European Commission for adjusting EU funds from current to constant prices, we get more significant declines for all countries (as shown in column 7). And the decline might be even higher for countries where average inflation in the period ahead is assumed to be above 2%, as for Hungary or Romania where inflation of around 3% is pencilled in.

Brexit itself is not a game-changer for the EU fund story As such, the lower EU funds proposal mainly relates to the structure of new EU budget, new criteria for the distribution of money and higher economic development of some CEE regions, not only the departure of the UK from the EU itself.

Importantly, a decline in the EU funds inflow to CEE regions might be partially offset by the fact that a higher co-financing rate is assumed and demanded in the new budget proposal. As such, direct EU funds should be complemented by other sources of financing (public or private) to increase the leverage of EU fund-supported investments.

Combining grants and financial instruments should be made easier in the new MFF 2021-27 and it includes also some special provisions to attract private capital. Still, employing own resources will be easier for countries with stronger fiscal positioning, such as the Czech Republic, Poland or Hungary, while others, such as Romania, might be less able to employ this option – please see the next section on this.

It should be noted, however, that the abovementioned budget represents the proposal - which is still a long way from being unanimously approved by the member states. Given the planned “rule of law and/or migration stance” criteria, reaching agreement will not be easy given the current stance of the Visegrad countries.

The prospect of lower EU fund distribution mainly relates to structure factors of the new budget rather than Brexit

Given the newly introduced “rule of law and/or migration stance” criteria, reaching an agreement on the new EU budget will not be easy


16

Scope for fiscal response – CE4 focus Brexit, in any scenario, opens the discussion on the fiscal leeway in the CEE countries to neutralise the adverse effect on growth/employment resulting from an external shock.

While the Brexit impact seems to be broadly manageable, a look at the fiscal buffers saved for rainy days is a good exercise given the relatively advanced phase of the US economic cycle, global trade disputes, lower growth in the EU, quantitative tightening and the risk of political vacuum in the EU after next year’s elections.

In case of a shock, monetary policy usually delivers the fastest response, but to achieve the optimal outcome it should be accompanied by automatic fiscal stabilisers.

In the Brexit case alone, fiscal spending might be needed to compensate for lower growth and, maybe, job losses, as well as higher co-financing needs for EU funds.

Fig 10 2019 fiscal outlook Fig 11 Rigid expenditure percentage of cyclically sensitive revenues

Source: AMECO Source: Eurostat, ING estimates

CEE countries have enjoyed robust growth over recent years on the back of an accommodative policy mix, solid external demand and rising wages in the context of tightening labour markets. In some cases this allowed the governments to build buffers, in others to redistribute the additional revenues within relatively sound fiscal policies, while one particular country has substantially altered its medium-term fiscal stability.

Bulgaria and the Czech Republic seem to enjoy reasonable room for accommodation as both countries have run fiscal surpluses over the past three years and have a positive structural balance as well.

While Poland and Hungary have a relatively comfortable headline budget balance, the EC estimates a much wider cyclically adjusted position for 2019, though with no deterioration signals for the former and even an improvement versus 2018 for the latter.

Romania stands out as an outlier with the EC seeing a deterioration in both the headline and the structural budget deficit. However, the government has so far managed to find patches to keep the headline budget deficit within the EDP limits.

For Romania, the commitment to the 3.0% of GDP budget deficit limit is the trade-off between the political costs for sticking to this ‘fiscal rule’ and those arising from entering the excessive deficit procedure (EDP), including lower budget flexibility.

In case of an external shock, the Romanian balancing act looks increasingly challenging. Hence Brexit could see relative vulnerability from the Romanian sovereign bond market, despite higher nominal yields.

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A look at the fiscal buffers saved for rainy days is a good exercise

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Romania stands out as an outlier with the EC seeing a deterioration in both the headline and the structural budget deficit


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Romania, followed by Poland have lower flexibility when it comes to fiscal adjustment without increasing taxes. This because the share of rigid expenditures (the wage envelope and social benefits) represents a higher proportion of cyclically sensitive revenues (fiscal revenues and the social contribution).

Conclusion We should not underestimate the impact Brexit could have on supply chains in the CEE region and the key sectors exposed. Autos, agriculture and textiles may suffer the biggest disruption.

In terms of the financial implications, Romania may be more exposed from a decline in remittances than Poland, since the Polish presence in the UK workforce is more mature.

Even though the loss of the UK’s budget contribution is meaningful, the bigger impact may come from the decline in the average GDP per capita level in the EU. This and fresh priorities will have profound implications for the 2021-27 budget round, potentially delivering 20%+ declines in real terms for the likes of the Czech Republic, Poland and Hungary.

Main authors: James Smith, Raoul Leering, Jakub Seidler, Ciprian Dascalu and Chris Turner, with help from the EMEA research team


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Countries


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Bulgaria Ciprian Dascalu, Chief Economist, Romania, Balkans

Forecast summary Country strategy: as good as it gets 2Q18 3Q18F 4Q18F 1Q19F 2Q19F 2018F 2019F

Real GDP (% YoY)* 3.0 3.0 3.7 3.3 3.0 3.3 3.5 CPI (% YoY)* 3.2 3.6 3.0 3.3 3.3 2.8 3.3 Central bank key rate (%)* 0.00 0.00 0.00 0.00 0.00 0.00 0.15 3m interest rate (%)* 0.00 -0.05 -0.05 -0.05 0.00 -0.02 0.05 10yr yield (%)* 0.98 1.04 1.04 1.14 1.24 1.08 1.25 USD/BGN* 1.67 1.70 1.70 1.70 1.66 1.68 1.64 EUR/BGN* 1.96 1.96 1.96 1.96 1.96 1.96 1.96

Macro Trend Political Cycle Ratings FC LC

Activity Presidential: Nov 21 S&P BBB- BBB- Fiscal Neutral Parliamentary: Apr 21 Moody’s Baa2 Baa2 Monetary Loose Local: Oct 19 Fitch BBB BBB

The economy is enjoying the best post-global financial crisis moments, but the convergence pace is slower than before the crisis. This is mainly due to lower potential GDP growth despite a pickup in productivity as the country is almost running out of labour resources and capital accumulation is sluggish. A pickup in investments, supported by EU funds, is likely to upgrade potential growth, but higher wages are failing to increase employment due to negative demographic trends. The ERM-II bid initially disappointed the government. An agreement has subsequently been reached on next steps ahead of entering the euro adoption waiting room expected in mid-2019, simultaneously with banking union. In the meantime, the CPI trajectory confirmed the ECB’s sustainability concerns.

*Quarterly data is eop, annual is avg. Source: National sources, ING estimates

Consumption and investments accelerate… Net exports dragging GDP growth down…

GDP growth was driven by private demand. The tight labour market is keeping wage growth in high single digits. This, along with weaker external demand, has led to a negative contribution from net exports to GDP growth. The external backdrop was behind the sequential contraction in manufacturing in 1Q18 which stalled in 2Q18. With the soft patch in Europe behind us, the first couple of third quarter readings point to acceleration in manufacturing. This is despite weaker confidence for the sector on the back of a lower export order book. Investments, both private and public, have a larger contribution, balancing the growth, with the latter reflecting the faster inflow of EU funds.

Source: NSI, ING

Soft and high frequency data points south… ...but domestic absorption should keep growth afloat

For the quarters ahead, economic sentiment suggests a deceleration in GDP growth, driven by both internal and external demand. Consumers turned more cautious in the third quarter, likely as inflation started to bite, leading to slower growth in real disposable income. The government’s intention to hike public sector salaries by 10% in January 2019 and a tight labour market are likely to keep upside pressure on wages. At the same time, monetary policy, which is imported from the ECB under the currency board FX regime, should remain accommodative for quite some time and the government has plenty of fiscal buffers to fend-off potential shocks.

Source: EC, NSI, ING

-6.0-4.0-2.00.02.04.06.08.0

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Others Consumption Investment

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859095100105110115120

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mailto:[email protected]


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Bulgaria 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018F 2019F 2020F

Activity Real GDP (% YoY) 6.0 -3.6 1.3 1.9 0.0 0.5 1.8 3.5 3.9 3.8 3.3 3.5 3.7 Private consumption (% YoY) 3.5 -4.4 1.1 1.9 3.0 -2.2 2.6 4.2 3.7 4.5 7.3 5.2 4.4 Government consumption (% YoY) 1.8 -5.9 2.0 2.2 -2.0 0.6 0.2 1.3 2.2 3.7 2.4 1.7 0.9 Investment (% YoY) 22.0 -17.7 -17.7 -4.4 1.8 0.3 3.4 2.7 -6.6 3.2 8.7 6.9 3.9 Industrial production (% YoY) 1.0 -18.3 1.9 6.2 -0.4 0.0 2.1 2.8 2.7 3.8 1.4 2.2 2.5 Unemployment rate (year-end, %) 5.6 6.9 10.3 11.3 12.3 13.0 11.4 9.1 7.6 6.2 5.0 4.7 4.5 Nominal GDP (BGNbn) 73 73 75 81 82 82 84 89 94 101 110 120 130 Nominal GDP (€bn) 37 37 38 41 42 42 43 45 48 52 56 61 66 Nominal GDP (US$bn) 55 52 51 58 54 56 57 50 53 59 65 74 85 GDP per capita (US$) 7,300 7,000 6,900 7,900 7,400 7,700 7,800 6,900 7,400 8,400 9,400 10,800 12,400 Gross domestic saving (% of GDP) 17.2 20.3 19.7 21.9 18.8 20.9 20.5 21.3 23.5 22.4 23.3 23.7 23.9

Prices CPI (average, % YoY) 12.4 2.8 2.4 4.2 3.0 0.9 -1.4 -0.1 -0.8 2.1 2.8 3.3 3.0 CPI (year-end, % YoY) 7.8 0.6 4.5 2.8 4.3 -1.6 -0.9 -0.4 0.1 2.8 3.0 3.6 2.5 Wage rates (nominal, % YoY) 28.1 12.0 7.2 8.0 5.6 8.6 2.4 7.9 7.0 10.5 7.6 11.2 7.2

Fiscal balance (% of GDP) Consolidated government balance 1.6 -4.1 -3.1 -2.0 -0.3 -0.4 -5.5 -1.6 0.2 0.9 0.6 -0.5 0.0 Consolidated primary balance 2.4 -3.3 -2.4 -1.2 0.5 0.4 -4.6 -0.7 1.1 1.7 1.3 0.2 0.5 Total public debt 13.0 13.7 15.3 15.2 16.7 17.0 27.0 26.0 29.0 25.4 22.7 21.3 19.7

External balance Exports (€bn) 15.2 11.7 15.6 20.3 20.8 22.3 22.0 22.9 24.0 26.6 28.2 30.1 32.1 Imports (€bn) 25.1 16.9 19.2 23.4 25.5 25.8 26.1 26.3 26.2 30.2 34.0 37.7 41.4 Trade balance (€bn) (9.9) (5.2) (3.7) (3.1) (4.7) (3.6) (4.1) (3.5) (2.1) (3.6) (5.7) (7.5) (9.2) Trade balance (% of GDP) -26.6 -13.9 -9.6 -7.6 -11.2 -8.5 -9.5 -7.7 -4.4 -7.0 -10.2 -12.3 -13.9 Current account balance (€bn) (8.2) (3.1) (0.7) 0.1 (0.4) 0.5 0.5 0.0 1.2 3.4 1.1 0.7 0.2 Current account balance (% of GDP) -22.0 -8.3 -1.7 0.3 -0.9 1.3 1.2 0.0 2.6 6.5 2.0 1.1 0.3 Net FDI (€bn) 5.9 2.5 0.9 1.2 1.1 1.2 0.1 2.2 0.6 1.1 1.4 1.7 2.0 Net FDI (% of GDP) 16.0 6.8 2.4 2.9 2.5 3.0 0.3 4.9 1.3 2.1 2.5 2.8 3.0 Current account balance plus FDI (% of GDP) -6.0 -1.6 0.7 3.2 1.7 4.2 1.6 4.9 3.9 8.6 4.5 3.9 3.3 Foreign exchange reserves ex-gold (€bn) 11.9 11.2 10.9 11.0 13.2 12.6 14.5 18.2 21.6 21.4 23.2 25.6 27.8 Import cover (months of merchandise imports) 5.7 8.0 6.8 5.7 6.2 5.8 6.7 8.3 9.9 8.5 8.2 8.2 8.1

Debt indicators Gross external debt (€bn) 37.2 37.8 37.0 36.3 37.7 36.9 39.3 33.3 34.0 32.6 33.2 33.9 34.6 Gross external debt (% of GDP) 100 101 97 88 90 88 92 74 71 63 59 55 52 Gross external debt (% of exports) 245 323 238 179 182 166 178 146 142 123 118 112 108 Lending to corporates/households (% of GDP) 66.4 68.6 67.8 64.8 65.6 65.5 59.2 55.0 52.3 51.6 53.3 55.2 57.2

Interest & exchange rates Central bank key rate (year-end, %) n/a n/a n/a n/a n/a n/a n/a n/a 0.00 0.00 0.00 0.15 0.40 Broad money supply (average, % YoY) 8.8 4.2 6.4 12.2 8.4 8.9 1.1 8.8 7.6 7.7 6.5 6.1 5.0 3m interest rate (Sofibor, average, %) 7.14 5.72 4.12 3.76 2.25 1.14 0.78 0.54 0.16 0.09 -0.02 0.05 0.45 3m interest rate spread over Euribor (ppt) 2.57 4.57 3.30 2.36 1.72 0.92 0.58 0.56 0.43 0.42 0.30 0.30 0.40 3yr yield (average, %) 5.3 5.7 4.7 3.7 2.7 1.5 1.6 1.0 0.5 0.2 0.0 0.2 0.5 10yr yield (average, %) 5.8 7.5 6.1 5.3 4.6 3.5 3.4 2.8 2.3 1.7 1.1 1.3 1.6 USD/BGN exchange rate (year-end) 1.33 1.40 1.46 1.40 1.52 1.47 1.48 1.78 1.86 1.63 1.70 1.56 1.50 USD/BGN exchange rate (average) 1.33 1.40 1.46 1.40 1.52 1.47 1.48 1.78 1.78 1.70 1.69 1.62 1.53 EUR/BGN exchange rate (year-end) 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 EUR/BGN exchange rate (average) 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96

Source: National sources, ING estimates

Quarterly forecasts 3Q17 4Q17 1Q18 2Q18 3Q18F 4Q18F 1Q19F 2Q19F 3Q19F 4Q19F 1Q20F 2Q20F 3Q20F

Real GDP (% YoY) 3.8 3.0 3.6 3.0 3.0 3.7 3.3 3.0 3.6 4.1 3.6 3.3 3.6 CPI (eop, % YoY) 2.1 2.8 2.2 3.2 3.6 3.0 3.3 3.3 3.4 3.6 3.3 3.0 2.7 Central bank key rate (eop, %) 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.15 0.25 0.25 0.40 3m interest rate (eop, %) 0.10 0.02 0.00 0.00 -0.05 -0.05 -0.05 0.00 0.10 0.15 0.40 0.40 0.50 10yr yield (eop, %) 1.47 1.13 1.24 0.98 1.04 1.04 1.14 1.24 1.29 1.34 1.39 1.39 1.44 USD/BGN exchange rate (eop) 1.63 1.63 1.63 1.67 1.70 1.70 1.70 1.66 1.63 1.56 1.55 1.54 1.53 EUR/BGN exchange rate (eop) 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96



21

Croatia Valentin Tataru, Economist, Romania

Forecast summary Country strategy: upgrade to investment grade in sight 2Q18 3Q18F 4Q18F 1Q19F 2Q19F 2018F 2019F

Real GDP (% YoY)* 2.9 2.5 2.4 2.3 2.5 2.6 2.5 CPI (% YoY)* 2.4 1.4 1.7 2.0 1.8 1.8 1.9 Central bank key rate (%)* 0.30 0.30 0.30 0.30 0.30 0.30 0.43 3m interest rate (%)* 0.50 0.50 0.50 0.55 0.55 0.50 0.63 10yr yield (%)* 2.20 2.20 2.40 2.40 2.50 2.25 2.50 USD/HRK* 6.31 6.48 6.32 6.13 5.92 6.33 5.90 EUR/HRK* 7.38 7.45 7.40 7.35 7.40 7.42 7.41


Activity Presidential: Dec-2019 S&P BB+ BB+ Fiscal Tighter Parliamentary: Sep-2020 Moody’s Ba2 Ba2 Monetary Loose Local: May-2021 Fitch BB+ BB+

With two outlook upgrades this year, from S&P and Fitch, the prospect of earning an investment grade rating within the next couple of years looks within reach. Moreover, the country intends to, and has real prospects of, joining the ERM II in 2020, though adopting the euro by 2022 is a different story. Solid domestic demand and another record year in tourism supported robust economic growth while fiscal consolidation continued and a phased tax reform was enacted. This partially addresses the increasingly worrying labour market shortage. The window of opportunity to step up reform could soon be closing though, as the next three years are marked by presidential, parliamentary and local elections, in a country traditionally prone to political instability.

*Quarterly data is eop, annual is avg Source: National sources, ING estimates

Real GDP (% YoY) and contributions (ppt) Moderate growth but still above potential

2Q18 GDP of 2.9% year-on-year, accelerated from 2.5% in 1Q18 as both private and public consumption maintained a steady pace whereas net exports have swung from a -2.2ppt contribution in 1Q18 to +1.3ppt in 2Q18. While strong domestic demand could result in a more pronounced deterioration of the trade balance, the current account surpluses are still well supported by strong tourism revenues. However, as tourists fly in, Croatians fly abroad which is starting to take its toll as the surplus trade in services seems to be levelling off. Moreover, industrial production continues to print weak numbers, which offers little back-up should a downturn in export services occur.

Source: Thomson Reuters, ING

Using the growth cycle for fiscal consolidation Sound fiscal stance but mind the one-offs

After 2017 marked the first year of fiscal surplus in its history, it seemed that the Croatian government was heading towards an even higher surplus in 2018, with strong VAT revenues and contained expenditures enabling quite rapid debt reduction and a longer maturity profile. However, what appeared to be a tail risk at some point seems to have materialised as the latest data point towards the activation of the state guarantees related to Uljanik shipyard activity. This will cost the Croatian government c.HRK4.2bn (c.1.1% of GDP), with c.HRK2.5bn to be paid in 2018, most likely sending the general budget into a small deficit this year. The rescue aid has been approved by the European Commission.

Source: Ministry of Finance, ING

-2-10123456

-2-10123456

2Q13 4Q13 2Q14 4Q14 2Q15 4Q15 2Q16 4Q16 2Q17 4Q17 2Q18

Private consumption Public consumptionInvestments Net exportsOthers GDP (%YoY,rhs)

-0.5

3.2

-8.0-6.0-4.0-2.00.02.04.06.0

2011 2012 2013 2014 2015 2016 2017 2018 2019

Budget balance Primary balance

ING forecast



22

Croatia 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018F 2019F 2020F

Activity Real GDP (% YoY) 2.0 -7.3 -1.5 -0.3 -2.3 -0.5 -0.1 2.4 3.5 2.9 2.6 2.5 2.1 Private consumption (% YoY) 1.3 -7.5 -1.4 0.3 -3.0 -1.9 -1.6 1.0 3.4 3.6 3.1 2.9 2.8 Government consumption (% YoY) -0.7 2.1 -0.6 -0.4 -0.8 0.6 1.8 -1.0 0.7 2.7 3.1 2.2 2.0 Investment (% YoY) 9.2 -14.4 -15.2 -2.7 -3.3 1.4 -2.8 3.8 6.5 3.8 6.2 6.0 6.0 Industrial production (% YoY) 1.0 -9.0 -1.4 -1.3 -5.4 -1.6 1.2 2.4 5.1 2.0 2.0 3.1 2.4 Unemployment rate (year-end, %) 8.6 9.3 11.8 13.7 15.8 17.4 17.2 16.1 13.4 11.0 8.0 7.5 7.0 Nominal GDP (HRKbn) 348 331 329 333 331 332 332 340 351 366 380 400 420 Nominal GDP (€bn) 48 45 45 45 44 44 43 45 47 49 51 54 57 Nominal GDP (US$bn) 71 63 61 63 57 58 57 49 51 56 60 68 77 GDP per capita (US$) 16,400 14,700 14,100 14,700 13,300 13,700 13,500 11,700 12,300 13,600 14,700 16,600 19,200 Gross domestic saving (% of GDP) 23.4 21.4 21.0 20.2 19.6 19.9 20.7 22.4 23.5 23.2 23.3 23.4 23.5

Prices CPI (average, % YoY) 6.1 2.4 1.0 2.3 3.4 2.2 -0.2 -0.5 -1.1 1.1 1.8 1.9 2.3 CPI (year-end, % YoY) 2.9 1.9 1.9 2.1 4.7 0.3 -0.5 -0.7 0.2 1.2 1.7 1.9 2.3 Wage rates (nominal, % YoY) 7.0 2.6 0.6 1.8 0.7 0.7 0.3 3.2 -0.4 5.3 5.4 5.5 5.7

Fiscal balance (% of GDP) Consolidated government balance -2.8 -6.0 -6.5 -7.8 -5.2 -5.3 -5.1 -3.4 -0.9 0.8 0.4 -0.5 -0.5 Consolidated primary balance -0.8 -3.7 -4.0 -5.0 -2.1 -2.1 -1.7 0.0 2.2 3.4 3.3 3.2 2.7 Total public debt 39.0 48.3 57.3 63.8 69.4 80.5 84.0 83.8 80.6 78.0 74.6 71.4 68.5

External balance Exports (€bn) 9.6 7.5 8.9 9.6 9.6 9.5 10.4 11.6 12.5 14.2 16.1 18.3 20.9 Imports (€bn) 20.9 15.2 15.1 16.3 16.2 16.6 17.2 18.5 19.8 21.9 24.2 26.8 29.6 Trade balance (€bn) -11.3 -7.7 -6.2 -6.7 -6.6 -7.0 -6.8 -6.9 -7.3 -7.7 -8.1 -8.5 -8.8 Trade balance (% of GDP) -23.4 -17.1 -13.8 -15.0 -15.0 -16.1 -15.6 -15.4 -15.7 -15.7 -15.8 -15.7 -15.5 Current account balance (€bn) -4.2 -2.3 -0.5 -0.3 -0.1 0.4 0.9 2.0 1.2 2.0 1.4 1.1 1.2 Current account balance (% of GDP) -8.8 -5.1 -1.1 -0.7 -0.1 0.9 2.0 4.5 2.6 4.0 2.7 2.0 2.1 Net FDI (€bn) 2.6 1.3 0.8 1.1 1.2 0.8 0.7 0.2 1.9 1.2 1.2 1.2 1.3 Net FDI (% of GDP) 5.5 2.8 1.8 2.5 2.8 1.9 1.6 0.5 4.1 2.4 2.4 2.3 2.2 Current account balance plus FDI (% of GDP) -3.3 -2.2 0.7 1.8 2.7 2.9 3.6 5.1 6.7 6.4 5.1 4.3 4.4 Foreign exchange reserves ex-gold (€bn) 9.1 10.4 10.7 11.2 11.2 12.9 12.7 13.7 13.5 15.7 16.7 17.7 19.2 Import cover (months of merchandise imports) 5.2 8.2 8.5 8.2 8.3 9.3 8.9 8.9 8.2 8.6 8.3 7.9 7.8

Debt indicators Gross external debt (€bn) 40.6 45.6 46.9 46.4 45.3 45.8 46.4 45.4 41.7 40.1 39.0 38.5 37.9 Gross external debt (% of GDP) 84 101 104 104 103 105 106.9 102 89 82 76 71 67 Gross external debt (% of exports) 423 608 527 484 470 480 446 390 334 282 242 210 182 Lending to corporates/households (% of GDP) 67.4 70.3 73.3 75.6 71.5 70.6 69.2 65.5 61.1 58.3 59.8 61.3 62.6

Interest & exchange rates Central bank key rate (year-end, %) 6.00 6.00 6.00 6.00 6.00 6.00 6.00 0.50 0.30 0.30 0.30 0.40 0.60 Broad money supply (average, % YoY) n/a -0.9 2.0 5.7 3.6 4.0 3.2 5.2 4.7 2.1 3.0 4.0 3.6 3m interest rate (Zibor, average, %) 7.2 9.0 2.4 3.2 3.4 1.5 1.0 1.2 0.9 0.6 0.5 0.6 0.8 3m interest rate spread over Euribor (ppt) 2.60 7.81 1.62 1.75 2.89 1.28 0.77 1.25 1.12 0.94 0.77 0.85 0.75 3yr yield (average, %) n/a n/a n/a n/a n/a 4.0 3.5 2.5 1.6 1.1 0.5 0.7 1.3 10yr yield (average, %) 6.0 7.8 6.3 6.5 6.1 5.0 4.3 3.6 3.5 2.7 2.3 2.6 2.7 USD/HRK exchange rate (year-end) 5.25 5.10 5.51 5.80 5.73 5.57 6.33 7.01 7.20 6.20 6.43 5.94 5.73 USD/HRK exchange rate (average) 4.91 5.24 5.44 5.31 5.83 5.70 5.78 6.92 6.85 6.55 6.40 6.13 5.80 EUR/HRK exchange rate (year-end) 7.36 7.30 7.38 7.54 7.56 7.63 7.66 7.64 7.56 7.44 7.40 7.42 7.45 EUR/HRK exchange rate (average) 7.22 7.34 7.29 7.44 7.52 7.58 7.63 7.61 7.53 7.46 7.42 7.42 7.43



Real GDP (% YoY) 3.4 2.2 2.5 2.9 2.5 2.4 2.3 2.5 2.8 2.4 1.8 1.9 2.4 CPI (eop, % YoY) 1.4 1.2 1.0 2.4 1.4 1.7 2.0 1.8 1.8 1.9 1.9 2.4 2.3 Central bank key rate (eop, %) 0.30 0.30 0.30 0.30 0.30 0.30 0.30 0.30 0.55 0.55 0.55 0.70 0.80 3m interest rate (eop, %) 0.60 0.59 0.50 0.50 0.50 0.50 0.55 0.55 0.70 0.70 0.75 0.85 0.95 10yr yield (eop, %) 2.59 2.44 2.20 2.20 2.20 2.40 2.40 2.50 2.50 2.60 2.70 2.70 2.70 USD/HRK exchange rate (eop) 6.21 6.18 6.19 6.31 6.48 6.32 6.13 5.92 5.82 5.71 5.61 5.48 5.40 EUR/HRK exchange rate (eop) 7.45 7.41 7.43 7.38 7.45 7.40 7.35 7.40 7.45 7.42 7.40 7.40 7.45



23

Czech Republic Jakub Seidler, Chief Economist Czech Republic

Forecast summary Country strategy 2Q18 3Q18F 4Q18F 1Q19F 2Q19F 2018F 2019F

Real GDP (% YoY) 2.4 2.7 2.7 2.9 2.9 3.0 2.9 CPI (% YoY)* 2.6 2.3 2.4 2.9 2.3 2.2 2.6 Policy interest rate (eop, %) 1.00 1.50 1.75 2.00 2.25 1.75 2.50 3m interest rate (%)* 1.16 1.70 1.95 2.20 2.45 1.26 2.42 10yr yield (%)* 2.19 2.19 2.20 2.30 2.40 2.05 2.35 USD/CZK* 22.24 22.21 22.61 22.35 21.69 22.11 21.14 EUR/CZK* 25.99 25.77 26.00 25.70 25.60 25.65 25.58


Activity Presidential: 2023 S&P AA- AA Fiscal Looser Parliamentary: 2021 Moody’s A1 A1 Monetary Tighter Local: 2020 Fitch AA- AA-

Czech GDP growth slowed to 3.3% in 1H18, after 4.5% growth in 2017. While last year’s growth was based on all parts of demand, this year growth is mostly driven by domestic demand, particularly household consumption and investments. Net exports are contributing negatively and imports are growing due to import-intensive investments. Exports have slowed on slightly weaker foreign demand and limited producer capacity. The overheated labour market is pushing wages up, contributing to solid household consumption and mounting inflationary pressures. The CNB wants to move interest rates from the zero-bound. Five hikes were delivered this year, and with the outlook for a more slowly appreciating CZK less sensitive to the interest rate differential, more hikes are likely next year.


Real GDP growth structure (ppt of YoY growth, SA adj) Macro digest

Czech GDP growth decelerated to 2.4% YoY in 2Q18. Though such a slowdown - from 4.1% in 1Q18 and 5% in 2H17 - seems substantial, it is partially driven by base effects. Growth in 2Q17 was particularly strong (at 2.4% QoQ). Average QoQ dynamics since 2016, however, stand at 0.8%, not significantly above the 2Q18 figure of 0.7%. While growth was broad-based in 2017, net exports are contributing negatively this year (-0.5ppt), as are inventories (-1.1ppt). Inventories is often used as a residual item if different GDP methodologies are providing inconsistent results. According to the CZSO, this had a role this time, together with some methodological changes and a high base from the last year. Household consumption remains strong (4% YoY in 1H18) and investments are accelerating (9% YoY), also due to government investments tapping EU funds. GDP growth should moderate towards 3% this year and next, consistent with the potential growth of the Czech economy.

The unemployment rate reached a new low in 2018 and remains the lowest in the EU. Job vacancies have been gradually increasing and approached 320,000 in September 2018. This is 50% higher than a year before and more than double the figure during the economic peak in 2008, before the global financial crisis. The overheated labour market has become the strongest barrier to further growth, as reported by almost 40% of industrial companies at the beginning of 3Q18. Labour force scarcity, accompanied by government measures to increase public-sector wages and the minimum wage are resulting in accelerating average wage growth. This reached 8.6% in 1H18 in nominal terms, and real wage growth of 6.4% is the highest of the last 15 years. Wage dynamics should remain strong, though not accelerating, next year due to the weaker economic activity broadly expected by the private sector.

The September CPI print slowed to 2.3% on price falls for package holidays which had accelerated at double digit rates during the summer months and returned back in September and with newly-introduced bus and rail fare discounts for pensioners and students across the country. Inflation should stay above 2.0% for the remainder of the year, resulting in an average level of 2.2% for this year. However, inflationary pressures will step up, not only due to the strong wage growth but also due to the rise in energy prices, especially electricity and gas for households. At the same time, food prices are expected to accelerate as a result of the weaker harvest following this year's drought. Altogether this means inflation should come close to the 3% threshold in the first half of next year. Total inflation will approach 2.6% next year.

Source: CZSO

Key activity indicators (% YoY)

Source: CZSO

Structure of inflation (ppt)

Source: CZSO, CNB

-3-11357

Change in inventories Foreign tradeGross fixed capital formation Final cons. expenditureYoY GDP growth (%)

2

4

6

8

-4

0

4

8

Real wages IP (3m-mav)Retail sales (3m-mav) Unemployment rate (rhs)

-1

0

1

2

3

Regulated prices Indirect taxes Food pricesCore inflation Fuel prices CPI (YoY, %)



24

Prague, +420 257 474 432 [email protected]

Mandatory and quasi-mandatory spending to GDP (%) Left-oriented government to increase mandatory spending

Though the state budget ended 2017 with a weak deficit of CZK6bn, municipalities generated a surplus due to lower investment activity. The total government balance reached the surplus of 1.5% of GDP. We expect a slightly weaker result this year, but still a surplus close to 1% of GDP, with total debt/GDP declining to 33%. Despite favourable economic conditions, the new left-oriented government plans a CZK40bn deficit for 2019, though, as in previous years, the final result might be better. Still, (quasi)mandatory spending is gradually increasing and will again be above 20% of GDP next year. Despite the fact that fiscal figures and total indebtedness are among the lowest in the EU, longer-term demographic challenges related to pension reforms or higher health spending remain.

Source: MinFin

Investment dynamics in the sectoral breakdown (% YoY) Investments to support GDP in the second half of the year

Investment activity related to EU funds withdrawal has become an important factor influencing GDP over the past couple of years. A government investment increase of 50% YoY at the end of 2015 was followed by a 50% decline in 2016. Tapping EU funds has been gradual so far in the new 2014-20 financial perspective (the Czech economy received EU funds of €23.8bn). Government investment activity soared by 23% YoY in 2Q18, as some of the EU funds should be withdrawn by the end of 2018 due to the N+3 rule. As such, strong investment activity is likely in the second half of the year. This will support GDP acceleration in 2H18. Importantly, private investments have also grown solidly this year and accelerated by 8.5% YoY in 1H18.

Source: CZSO

Growth in property prices (% YoY) Property prices are slowing after strong 2017

Based on the House Price Index, the measure of residential property prices including prices of both existing and new family houses, flats and land using a unified methodology in the EU, Czech property prices rose by 12% in 2017. This was the highest in the EU as a result of increasing demand driven by favourable economic growth, but also limited supply due to administrative obstacles caused by legislation. Recent figures indicate that 2018 will bring a slowdown to the Czech property market as price growth reached 7.6% in 1H18. Deceleration will most likely continue due to gradually increasing mortgage rates and tighter macro-prudential measures. Still, as the number of started and finished apartments is significantly lagging demand, more pronounced price declines are unlikely.

Source: Eurostat

Sets in the lower house and the Senate Government parties did not succeed in the Senate

Lower house Senate

ANO 78 7 CSSD 15 13 KSCM 15 0 ODS 25 12 SPD 22 0 Pirati 22 1 TOP09 7 0 KDU-CSL 10 15 STAN 6 16 Others 17 Total 200 81

PM Andrej Babis (ANO) formed a minority government with the previous coalition party CSSD, after other traditional parties decided not to negotiate with Babis. As such, government survival is enabled by Communistic Party (KSCM) support. Although ANO was successful in the local elections (excluding Prague), Senate elections were a failure for all government parties including KSCM. The opposition right-oriented ODS party exceeded expectations. Government parties did not get a majority in the Senate, with 13 CSSD and 7 ANO. Though a Senate veto might be overridden by a 101 majority vote of the lower house, any constitutional and election-law changes need Senate approval. This might, however, provide a backstop for potential populist initiatives.

Source: CZSO

0

10

20

30

09 10 11 12 13 14 15 16 17 18 19

MandatoryQuasi mandatoryTotal (mandatory & quasi mandatory) expenses

-50

-30

-10

10

30

50

Governemnt Corporates Households

0 2 4 6 8 10 12

EU28EUDEROPLCZSKNLHU

2017

1H18



25

Czech Republic Strategy

FX – spot vs forward and INGF FX strategy (with Petr Krpata, Chief EMEA FX and IR Strategist)

The CNB delivered five hikes in 2018 on the back of a relatively weak CZK. CZK has been soft since April 2018 due to a challenging global environment and a shift in investor preferences out of EMs. CZK positioning remains heavily one-sided due to FX interventions at the turn of 2016/2017, making CZK appreciation more difficult.

November CNB projections expect CZK to start appreciating strongly next year as the CNB assumes that the current non-friendly global environment for EM FX vanishes in early 2019 and CZK re-connects with the high interest rate differential. The new CNB forecast projects EUR/CZK at 25.10 in 1Q19 and 24.40 in 4Q19.

We have difficulty seeing such a strong and quick pace of CZK appreciation. This is because: (1) the EM environment is likely to remain tricky even in the first half of 2019 due to trade wars (we expect more tariffs from the US on Chinese imports); (2) the Fed continuing hiking; (3) CZK remains overbought; and (4) compared to previous years, EUR/CZK is no longer materially overvalued (only 1% based on our BEER model estimate) due in part to its real appreciation stemming from higher inflation and wages growth. As such, we only expect EUR/CZK to reach 25.20 by end 2019, conditional on the CNB continuing the needed hiking cycle to prevent CZK from weakening and pushing it modestly higher. For the remainder of the year, however, we look for further CZK weakness and EUR/CZK testing 26.00 as the decline in short-term implied yields due to resolution fund weighs on the koruna. We look for EUR/CZK forward points to continue pushing higher given the risk of the continued frontloaded hiking cycle.

Source: Bloomberg, ING Bank

Foreign holders of CZGB (%)

Source: CZSO, ING Bank

Local curve (%)

Source: Bloomberg, ING Bank

CNB is pencilling plenty of tightening next year

Source: ING, CNB

24.525.025.526.026.527.027.528.028.5

ING f'cast Mkt fwd

0

200

400

600

800

-82

1222324252

03/1

5

06/1

5

09/1

5

12/1

5

03/1

6

06/1

6

09/1

6

12/1

6

03/1

7

06/1

7

09/1

7

12/1

7

03/1

8

06/1

8

09/1

8

CZK bn (rhs) The share of foreign holders

1.00

1.25

1.50

1.75

2.00

2.25

2.50

2.75

Now -3 Months +3 Months

0

2

4

6

8

1Q19 2Q19 3Q19 4Q19 1Q20 2Q20

FX Interest Rate Total

Number of implied interest rate hikes via the mix of FX and Rates channels from November CNB QIR (assuming the CNB equivalence rule of 1% EUR/CZK depreciation = one 25bp repo hike)

Three implied rate hikes

expected in 1Q19


26

Czech Republic 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018F 2019F 2020F

Activity Real GDP (% YoY) 2.5 -4.7 2.1 1.8 -0.7 -0.5 2.7 5.4 2.4 4.5 3.0 2.9 2.8 Private consumption (% YoY) 2.8 -0.5 1.0 0.3 -1.2 0.5 1.8 3.8 3.6 4.4 3.7 3.6 3.1 Government consumption (% YoY) 1.2 2.8 0.5 -3.2 -2.0 2.5 1.1 1.9 2.7 1.3 2.8 1.8 1.3 Investment (% YoY) 2.3 -9.7 1.0 1.0 -2.9 -2.5 4.0 10.4 -3.2 3.7 6.5 4.0 3.6 Industrial production (% YoY) -1.5 -13.2 8.6 6.1 -0.7 0.1 5.0 4.3 3.6 6.5 3.2 3.0 2.9 Unemployment rate (year-end, %) 4.7 7.4 6.9 6.5 7.1 6.7 5.8 4.5 3.5 2.4 2.2 2.0 2.0 Nominal GDP (CZKbn) 4,020 3,932 3,958 4,030 4,059 4,097 4,313 4,598 4,766 5,052 5,308 5,572 5,836 Nominal GDP (€bn) 161 149 157 164 161 158 157 169 176 192 207 218 234 Nominal GDP (US$bn) 236 206 207 228 208 209 208 187 195 216 240 264 300 GDP per capita (US$) 22,701 19,741 19,809 21,719 19,730 19,916 19,745 17,715 18,464 20,367 22,626 24,868 28,314 Gross domestic saving (% of GDP) 33.3 30.4 30.2 31.0 31.2 30.6 32.0 33.1 32.5 33.1 32.8 32.7 32.7

Prices CPI (average, % YoY) 6.4 1.1 1.5 1.9 3.3 1.4 0.4 0.3 0.7 2.5 2.2 2.6 2.3 CPI (year-end, % YoY) 3.6 1.0 2.3 2.4 2.4 1.4 0.1 0.1 2.0 2.4 2.4 2.6 2.1 Wage rates (nominal, % YoY) 7.9 3.4 2.2 2.5 2.5 -0.1 2.9 3.2 4.5 6.2 8.2 6.8 5.2

Fiscal balance (% of GDP) Consolidated government balance -2.0 -5.5 -4.2 -2.7 -3.9 -1.2 -2.1 -0.6 0.7 1.5 1.4 0.9 0.3 Consolidated primary balance -1.1 -4.3 -3.1 -1.4 -2.5 0.1 -0.6 0.4 1.6 2.3 2.2 1.7 1.1 Total public debt 28.3 33.6 37.4 39.8 44.5 44.9 42.2 40.0 36.8 34.7 32.8 31.4 31.1

External balance Exports (€bn) 85.2 72.2 87.0 99.2 104.3 103.0 110.3 115.6 118.0 128.6 133.6 138.6 143.4 Imports (€bn) 86.0 69.7 85.5 96.1 99.3 96.6 102.3 108.7 108.9 119.5 125.1 130.5 135.6 Trade balance (€bn) -0.8 2.4 1.6 3.1 4.9 6.4 8.0 6.9 9.1 9.1 8.5 8.1 7.8 Trade balance (% of GDP) -0.5 1.6 1.0 1.9 3.0 4.1 5.1 4.1 5.1 4.7 4.1 3.7 3.3 Current account balance (€bn) -3.1 -3.5 -5.8 -3.5 -2.5 -0.8 0.3 0.4 2.7 1.9 1.8 0.8 0.4 Current account balance (% of GDP) -1.9 -2.3 -3.7 -2.1 -1.6 -0.5 0.2 0.2 1.5 1.0 0.8 0.4 0.2 Net FDI (€bn) 1.5 1.4 3.8 1.9 4.8 -0.2 2.9 -1.8 6.9 5.1 2.7 2.5 2.0 Net FDI (% of GDP) 0.9 0.9 2.4 1.1 3.0 -0.2 1.9 -1.1 3.9 2.7 1.3 1.1 0.9 Current account balance plus FDI (% of GDP) -1.0 -1.4 -1.3 -1.0 1.4 -0.7 2.0 -0.9 5.5 3.7 2.2 1.5 1.0 Foreign exchange reserves ex gold (€bn) 26.5 28.9 31.7 30.8 33.9 40.7 45.1 59.6 80.9 123.1 128.3 133.6 139.0 Import cover (months of merchandise imports) 3.7 5.0 4.4 3.8 4.1 5.1 5.3 6.6 8.9 12.4 12.3 12.3 12.3


Interest & exchange rates Central bank key rate (year-end, %) 2.25 1.00 0.75 0.75 0.05 0.05 0.05 0.05 0.05 0.50 1.75 2.50 3.00 Broad money supply (average, % YoY) 13.3 8.1 1.5 2.1 5.6 4.7 5.4 7.9 8.6 9.5 6.8 5.8 5.5 3m interest rate (Pribor, average, %) 4.04 2.19 1.31 1.19 1.00 0.46 0.36 0.31 0.29 0.41 1.26 2.42 3.01 3m interest rate spread over Euribor (ppt) -59.7 96.3 50.2 -20.1 42.5 23.6 14.7 32.8 55.3 73.7 158.1 266.5 296 2yr yield (average, %) 4.0 2.7 1.6 1.7 0.9 0.3 0.2 -0.1 -0.3 -0.2 1.1 1.9 2.1 10yr yield (average, %) 4.6 4.7 3.9 3.8 2.8 2.1 1.6 0.7 0.4 1.1 2.1 2.3 2.7 USD/CZK exchange rate (year-end) 19.22 18.47 18.69 19.74 19.01 19.89 22.86 24.87 25.70 21.29 22.61 20.16 18.90 USD/CZK exchange rate (average) 17.07 19.06 19.10 17.69 19.55 19.56 20.76 24.59 24.44 23.38 22.11 21.14 19.45 EUR/CZK exchange rate (year-end) 26.85 26.44 25.02 25.59 25.10 27.34 27.66 27.02 27.02 25.51 26.00 25.20 24.58 EUR/CZK exchange rate (average) 24.96 26.45 25.29 24.59 25.13 25.98 27.53 27.28 27.03 26.33 25.65 25.58 24.89



Real GDP (% YoY) 5.1 5.0 4.1 2.4 2.7 2.7 2.9 2.9 2.8 2.8 2.8 2.8 2.8 CPI (eop, % YoY) 2.7 2.4 1.7 2.6 2.3 2.4 2.9 2.3 2.6 2.6 2.5 2.5 2.2 Central bank key rate (eop, %) 0.25 0.50 0.75 1.00 1.50 1.75 2.00 2.25 2.50 2.50 2.75 2.75 3.00 3m interest rate (eop, %) 0.47 0.76 0.90 1.16 1.70 1.95 2.20 2.45 2.70 2.70 2.95 2.95 3.20 10yr yield (eop, %) 1.34 1.72 1.88 2.19 2.19 2.20 2.30 2.40 2.40 2.40 2.40 2.40 3.10 USD/CZK exchange rate (eop) 22.00 21.29 20.56 22.24 22.21 22.61 22.35 21.69 21.17 20.16 19.88 19.60 19.32 EUR/CZK exchange rate (eop) 25.99 25.51 25.35 25.99 25.77 26.00 25.70 25.60 25.40 25.20 25.04 24.89 24.73



27

Hungary Péter Virovácz, Senior Economist, Hungary


Real GDP (% YoY) 4.7 4.3 3.7 3.5 3.5 4.3 3.3 CPI (% YoY)* 3.1 3.6 3.6 3.5 3.4 3.0 3.4 Policy interest rate (eop, %) 0.90 0.90 0.90 0.90 0.90 0.90 0.90 3m interest rate (%)* 0.26 0.17 0.16 0.20 0.30 0.13 0.43 10yr yield (%)* 3.62 3.55 3.65 3.65 3.75 3.1 3.8 USD/HUF* 281.4 281.2 282.6 282.6 271.2 276.0 263.6 EUR/HUF* 329.3 323.4 325.0 325.0 320.0 320.2 319.0


Activity Presidential: 2022 S&P BBB- BBB- Fiscal Tighter Parliamentary: 2022 Moody’s Baa3 Baa3 Monetary Tighter Local: 2019 Fitch BBB- BBB-

Real GDP increased by 4.7% YoY in 1H18, the best reading since 2004. However, based on our LeadING HUBE indicators, we think economic activity has peaked. The seasonally and calendar-adjusted data also suggest that the economy is heading towards a more moderate growth path. Regarding 2018 as a whole, we expect 4.3% YoY GDP growth. The fiscal stance is in line with the government’s plan or is even better. In view of the underlying factors, the 2.4% deficit target is not in jeopardy. Looking forward to 2019, the NBH will be in the limelight. Inflation has started to accelerate, pointing to an above 3% YoY average reading for next year. Core inflation is still below the 3% target, but could suddenly change. We expect the NBH to start policy normalisation in 2H19.


Contribution to YoY GDP growth (ppt) Macro digest

GDP growth came in at 4.1% in 2017 and continued its acceleration in the first half of 2018 mainly on the carry-over effect. The 1H18 4.7% YoY economic activity growth was the highest growth since early-2006. On the other hand, we see several signs that the economy has just passed its peak and Hungary is heading towards a downslope in GDP growth.

On the main drivers, we see few significant changes compared to 2017. The services sector has been the main contributor with its 2.6ppt effect in 1H18, although we have recently seen a deceleration in the sector. Despite the high base, construction grew by 22.4% YoY in the first half of 2018, mainly on EU-funded infrastructure projects and capacity enhancements in the industry. Constraints in labour and capital caused a mild slowdown in industrial value added, but it still made a 0.7ppt contribution to GDP growth, the second highest of all the sectors. After a bad year in 2017, agriculture has had a neutral growth effect so far in 2018.

On the final use side, domestic demand has remained to the fore. The significant pickup in consumption and investments jointly resulted in a 4.9ppt contribution to economic expansion in 1H18. However, the growth rate of domestic demand has decelerated, despite the fact that the labour market has never been so tight and real wages are still increasing fast. Net exports dragged GDP growth down by 0.2ppt on the back of moderated industrial production and still-strong domestic demand.

For the rest of 2018, we see a mild correction based on the recent high frequency data releases. We forecast 4.3% YoY GDP growth in 2018 as a whole. We see economic activity decelerating to 3.3% YoY in 2019 as a result of a weakened fiscal impact, the start of monetary tightening, decelerating external demand and the lack of room for improvement in the labour market.

Headline CPI came in at 3.8% YoY in October, pushing the year-to-date inflation figure to 2.8% YoY (0.5ppt higher than last year’s average). Price pressure strengthened, mainly on food, energy and alcoholic beverages and tobacco products due to supply shocks and excise duty changes. Meanwhile, inflation in services and durables has slowly but surely accelerated recently, translating into a 2.4% YoY core inflation in the first ten months of 2018. Other underlying measures of inflation are also suggesting strengthening inflationary pressure. According to the NBH, core CPI will likely reach the 3% target by mid-2019. We tend to agree with this but see significant upside risks. A weaker HUF, higher energy prices and increasing unit labour costs might prove too much to bear, pushing companies to change prices suddenly and significantly in early 2019.

Source: Hungarian Central Statistical Office

Key activity indicators (swda; 2015 = 100%)

Source: Eurostat, Hungarian Central Statistical Office

Headline and underlying measures of inflation (% YoY)

Source: National Bank of Hungary

-6-4-202468

Final consumption GFCFInventories Net exportsGDP

708090

100110120130140

Retail sales Construction outputIndustrial production Economic Sentiment Index

-0.50.00.51.01.52.02.53.03.54.0

CPI Core infl. ex. indirect taxesDemand sensitive inflation Sticky price inflation



28

Budapest, +36 1 235 8757 [email protected]

Budget and structural balance of gen. government (%) Underlying budgetary processes are favourable

The government has continued to pre-finance EU projects in 2018, resulting in a large financial gap (c.HUF1,150bn) between the pre-financed projects and actual inflows from Brussels. However, the government has recently decided to slow the pace of disbursement transfer in order to balance its financing needs. When it comes to the Maastricht deficit target (2.4% of GDP), we don’t see any major downward risks. Favourable underlying factors (better-than-expected inflow from VAT, PIT and payroll tax) and the positive GDP story support our view that we could have an even lower deficit than originally planned. We see a marginal decrease in public debt to GDP in 2018. As for 2019, the debt is likely to decline more significantly as EU money will finally come in.

Source: AMECO, ING, National Bank of Hungary

Benchmark policy rate and interest rate corridor The NBH is prepared to change its stance… if needed

The NBH sold a still-loose monetary policy as a tightening at its September meeting. Regarding the short-end of the yield curve, the 3m deposit facility was ended, with the new main instrument being the interest rate on the reserve requirement. As for the long end, the ‘Funding for Growth Scheme Fix’ will be introduced with HUF1tr in 2019. In addition to this, the MIRS and mortgage bond purchase programme will be abolished from the start of 2019. According to our base case, the first rate hike could come in early-2020, although 3m Bubor is likely to start approaching the base rate in 2019. However, as Matolcsy’s term ends in March 2019, it gives an opportunity for the new governor to accelerate the monetary policy normalisation if core CPI grows fast.

Source: Bloomberg

Wage growth (% YoY, 3m-mav) The fight for labour drives wage growth

With the number of unemployed at 170k in 3Q18 and the number of job vacancies at 51k in 3Q18, the labour market has never been tighter. The combination of labour shortages and an increase in minimum wages resulted in double-digit wage growth (11.8% YoY) in the first eight months of 2018. However, the broadly unchanged unemployment and employment readings suggest the pace of improvement is gradually slowing. We expect the fight for labour to continue in 2019, while the government might increase minimum wages further. Payroll tax will be cut from July 2019, easing wage pressure on companies. We expect wages to rise by 9% YoY in 2019, while the unemployment rate will stabilise around 3.5%, a rate consistent with full employment.

Source: Bloomberg, ING

Market pricing compared to the EMEA sovereign ratings No further rating upgrade earlier than 1H19

While we hoped for upgrades from S&P and Fitch in 2018, both just affirmed the Hungarian credit rating at ‘BBB-’ with the outlook remaining positive. With Moody’s being next in line in November, Hungary could leave 2018 without a rating upgrade. Both S&P and Fitch have emphasised lately – among other things – that the government has made only slight progress in reducing high public debt, while also highlighting weak checks and balances. As for 2019, we see an upgrade from Fitch and S&P and at least an outlook upgrade from Moody’s (if this doesn’t come in November 2018). Considering the market moves, it is apparent that Hungary has already been priced by the market as a ‘BBB’ category sovereign, so we don’t expect any harsh reaction on possible upgrades.


-6-5-4-3-2-10

Budget balance Structural balanceMaastricht criteria MTO

Forecast

-0.5%0.0%0.5%1.0%1.5%2.0%2.5%

Key policy rate Interest rate on O/N loanInterest rate on O/N deposit Bubor 3-m

-5

0

5

10

15

20

Public Private Total

0

100

200

300

400

500

Standard & Poor's rating

Hungary

AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B-

CDS (1-m avg)



29

Hungary Strategy

FX – spot vs forward and INGF FX strategy (with Petr Krpata, Chief EMEA FX and IR Strategist)

We modestly downgrade our year-end EUR/HUF forecast to 325 and don’t expect the cross to re-test the 330 level this year. To the extent to which missteps by the NBH during the first part of the year led the market to question its credibility and weakened HUF, the central bank’s more cautious approach in 2H18 (ie, communicating its intention to gradually exit its ultra-loose monetary stance; lower volatility in Bubor) should help to prevent a more aggressive HUF decline. The bulk of the HUF fall in June/July coincided with the sharp spike in Bubor. As the interbank rate is now managed more efficiently, this suggests less scope for sharp HUF declines, particularly in the context of the very stretched short-HUF positioning.

Still, we expect EUR/HUF to trade water ahead of the likely gentle start of the NBH Bubor normalisation in 2Q19, with market participants unwilling to commit to high conviction HUF longs due to concerns about the execution of the Bubor normalisation. Externally, we expect the trade war overhang to remain in markets, limiting the upside potential to EM FX.

However, once/if the NBH delivers a well behaved Bubor normalisation, HUF will have scope to rally in large part due to the very stretched short positioning as well as non-negligible undervaluation vs EUR. Coupled with the view that EUR/USD should rebound in 2H, this can lead to EUR/HUF briefly re-testing 310 in 2H19.

HUF benefits from highest current account surplus in the CEE region, though the external position has been meaningfully deteriorating. This should limit the scale of potential upside versus previous years.

Source: Bloomberg

Evolution of gross external debt (% of GDP)


Local curve (%)

Source: Bloomberg

Steepness of the local curve (bp)


300305310315320325330335

ING f'cast Mkt fwd Mkt consensus

020406080

100120140160

Forecast

1.52.02.53.03.54.04.5

10yr yield – ING f'cast 10yr yield – Mkt consensus (median)

50

100

150

200

250

10Y-5Y spread 10Y-3Y spread


30

Hungary 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018F 2019F 2020F

Activity Real GDP (% YoY) 0.9 -6.6 0.7 1.7 -1.6 2.1 4.2 3.5 2.3 4.1 4.3 3.3 2.7 Private consumption (% YoY) -1.1 -6.8 -2.7 0.7 -2.4 0.2 2.8 3.9 4.0 4.7 5.3 4.1 3.4 Government consumption (% YoY) 3.1 3.2 2.3 0.0 -0.2 6.6 10.0 0.0 0.9 2.0 0.5 0.2 0.3 Investment (% YoY) 1.0 -8.3 -9.5 -1.3 -3.0 9.8 12.3 4.7 -11.7 18.2 14.6 7.1 2.8 Industrial production (% YoY) 0.0 -17.8 10.6 5.6 -1.8 1.1 7.7 7.4 0.9 4.6 3.8 5.0 7.0 Unemployment rate (year-end, %) 8.1 10.5 10.9 10.8 10.7 9.2 7.2 6.2 4.5 3.8 3.6 3.5 3.4 Nominal GDP (HUFbn) 27,194 26,425 27,225 28,305 28,781 30,248 32,583 34,379 35,474 38,355 41,615 44,695 47,377 Nominal GDP (€bn) 108 94 99 101 99 102 106 111 114 124 130 140 153 Nominal GDP (US$bn) 159 132 132 142 128 135 139 122 125 141 151 170 196 GDP per capita (US$) 15,844 13,024 13,061 14,106 12,858 13,645 14,191 12,462 12,802 14,209 15,639 17,677 20,502 Gross domestic saving (% of GDP) 17.6 19.5 20.9 21.2 21.2 24.9 24.8 25.3 25.8 25.7 25.6 25.5 25.3

Prices CPI (average, % YoY) 6.1 4.2 4.9 3.9 5.7 1.7 -0.2 -0.1 0.4 2.4 3.0 3.4 3.0 CPI (year-end, % YoY) 3.5 5.6 4.7 4.1 5.0 0.4 -0.9 0.9 1.8 2.1 3.6 3.2 3.0 Wage rates (nominal, % YoY) 7.4 0.6 1.3 5.2 4.7 3.4 3.0 4.3 6.1 12.9 12.0 9.0 6.0

Fiscal balance (% of GDP) Consolidated government balance -3.7 -4.5 -4.5 -5.4 -2.4 -2.6 -2.6 -2.0 -1.7 -2.2 -2.0 -1.8 -1.5 Consolidated primary balance 0.3 -0.2 -0.4 -1.2 2.1 1.4 1.4 1.2 1.7 0.6 0.4 0.6 0.9 Total public debt 71.6 77.8 80.2 80.5 78.4 77.1 76.6 76.6 75.9 73.3 73.0 70.0 67.5

External balance Exports (€bn) 73.4 59.1 71.4 80.0 80.0 81.3 84.5 90.5 93.0 100.7 106.1 112.5 120.0 Imports (€bn) 73.7 55.4 65.9 72.9 73.3 74.7 78.2 81.9 83.3 92.6 99.5 106.3 111.5 Trade balance (€bn) -0.3 3.7 5.5 7.1 6.7 6.6 6.3 8.6 9.7 8.1 6.6 6.2 8.5 Trade balance (% of GDP) -0.3 4.0 5.6 7.0 6.7 6.4 5.9 7.7 8.5 6.5 5.1 4.4 5.6 Current account balance (€bn) -7.6 -0.8 0.3 0.8 1.8 3.9 1.6 3.1 7.1 3.9 2.4 2.4 3.7 Current account balance (% of GDP) -7.0 -0.8 0.3 0.7 1.8 3.8 1.5 2.8 6.2 3.2 1.8 1.7 2.4 Net FDI (€bn) 3.1 1.3 1.2 1.6 3.9 1.9 5.0 2.1 3.6 4.5 1.8 3.4 4.8 Net FDI (% of GDP) 2.9 1.4 1.2 1.5 4.0 1.9 4.8 1.9 3.1 3.6 1.4 2.4 3.1 Current account balance plus FDI (% of GDP) -4.2 0.6 1.5 2.3 5.7 5.7 6.3 4.7 9.4 6.8 3.2 4.1 5.5 Foreign exchange reserves ex gold (€bn) 23.6 28.5 32.3 35.1 31.8 32.6 33.7 30.0 24.0 22.6 22.9 23.2 23.5 Import cover (months of merchandise imports) 3.8 6.2 5.9 5.8 5.2 5.2 5.2 4.4 3.5 2.9 2.8 2.6 2.5


Interest & exchange rates Central bank key rate (year-end, %) 10.00 6.25 5.75 7.00 5.75 3.00 2.10 1.35 0.90 0.90 0.90 0.90 1.25 Broad money supply (average, % YoY) 10.0 8.8 2.8 2.5 -1.3 4.1 4.1 4.7 4.6 9.6 15.4 7.1 2.5 3m interest rate (Bubor, average, %) 8.86 8.64 5.50 6.19 7.00 4.32 2.41 1.61 0.99 0.15 0.13 0.43 1.14 3m interest rate spread over Euribor (ppt) 429 749 468 479 647 410 221 163 126 48 45 68 109 2yr yield (average, %) 9.4 9.3 6.7 7.0 7.5 4.8 3.6 2.1 1.5 0.9 1.3 1.6 2.2 10yr yield (average, %) 8.2 9.1 7.3 7.6 7.9 5.9 4.8 3.4 3.1 3.0 3.1 3.8 4.0 USD/HUF exchange rate (year-end) 189.1 189.4 208.0 239.3 220.7 216.7 260.2 287.3 296.2 258.5 282.6 248.0 238.5 USD/HUF exchange rate (average) 170.9 200.4 205.5 199.4 224.4 223.2 233.8 281.7 283.1 271.2 276.0 263.6 242.2 EUR/HUF exchange rate (year-end) 264.8 270.8 278.8 311.1 291.3 296.9 314.9 313.1 311.0 310.1 325.0 310.0 310.0 EUR/HUF exchange rate (average) 251.3 280.6 275.4 279.2 289.4 296.9 308.7 309.9 311.5 309.2 320.2 319.0 310.0



Real GDP (% YoY) 3.9 4.4 4.5 4.7 4.3 3.7 3.5 3.5 3.2 3.0 2.8 2.7 2.6 CPI (eop, % YoY) 2.7 2.1 2.0 3.1 3.6 3.6 3.5 3.4 3.4 3.2 3.1 3.0 3.0 Central bank key rate (eop, %) 0.90 0.90 0.90 0.90 0.90 0.90 0.90 0.90 0.90 0.90 1.05 1.25 1.25 3m interest rate (eop, %) 0.04 0.03 0.03 0.26 0.17 0.16 0.20 0.30 0.60 0.90 1.05 1.25 1.25 10yr yield (eop, %) 2.62 2.02 2.39 3.62 3.55 3.65 3.65 3.75 3.85 3.90 3.95 4.00 4.00 USD/HUF exchange rate (eop) 259.7 259.0 260.4 281.4 281.2 282.6 282.6 271.2 262.5 248.0 246.0 244.1 242.2 EUR/HUF exchange rate (eop) 311.6 310.8 312.5 329.3 323.4 325.0 325.0 320.0 315.0 310.0 310.0 310.0 310.0



31

Kazakhstan Dmitry Dolgin, Chief Economist, Russia & CIS


Real GDP (% YoY) 4.1 3.8 3.5 3.2 3.4 3.9 3.5 CPI (% YoY)* 5.9 6.1 6.0 6.5 6.5 6.3 6.3 Policy interest rate (eop, %) 9.00 9.00 9.25 9.25 9.25 9.25 8.00 3m interest rate (%)* 10.00 10.00 10.25 10.25 10.25 10.40 10.00 10yr yield (%)* n/a n/a n/a n/a n/a n/a n/a USD/KZT* 341 363 350 340 350 341 354 EUR/KZT* 399 418 403 391 413 396 428


Activity Presidential: 2020 S&P BBB- BBB- Fiscal Tighter Parliamentary: 2021 Moody’s (P)Baa3 WR Monetary Neutral Local: Fitch BBB BBB

We have a constructive view on the GDP growth story that, unlike the country’s financial flows, is diversified away from oil. We welcome the government’s efforts to build fiscal buffers, which should reinforce the perception of the country risk. For now, we concur with consensus expecting stabilisation of FX and CPI. Yet, the still high dependence of financial flows on the volatile external variables, such as oil price, state of global trade and EM portfolio inflows, remain a risk factor. A lack of clarity on the political succession in 2020 alongside the country’s recovering but still weak banking sector will remain key local factors of uncertainty on the key indicators, mainly fiscal. As with Russia and China, Kazakhstan’s trade partners, risks to our forecasts are skewed to the downside.

*Quarterly data is eop, annual is avg. Source: National sources, ING estimates

GDP growth structure (% YoY) GDP growth well supported

GDP growth has stabilised at around 3-4% YoY, as the moderation in the fuel sector (25% of the value added) given the slowing oil output is offset by faster growth in other sectors (manufacturing, trade, finance), motivated by ongoing reforms and the 4% GDP fiscal support to the financial sector disbursed in 2017. Going forward, private consumption should be supported by the upcoming cut in income tax for low-income earners. The growth story should also be supported by net exports through the higher flexibility of the tenge (resulting in lower imports). The export side (80% oil) appears less clear, with more than 40% of the total dependent on Italy, China and Russia – countries with elevated slowdown risk at the moment.

Source: CEIC, ING

CA/fiscal balance vs oil price External/fiscal position still depends on oil

With the current ING view on the oil price, the deficits of the current account and the budget are set to shrink materially in 2018, but as Brent oil is projected to fall from US$75/bbl in 2018 to US$66-69/bbl in 2019-20, the stability of the external and fiscal positions will depend on the ability to deliver a better non-oil balance. Each US$10/bbl move in the oil price translates into export revenues of almost 6% of GDP and headline budget revenues of 1% of GDP. Kazakhstan is in the process of fiscal consolidation on the spending and non-oil-revenue side, while the structural reforms could help the country to attract more FDI, and even tackle the global debt market. Kazakhstan raised funds in 5yr €0.5bn and 10yr €0.5bn Eurobonds in Nov 2018.

Source: CEIC, ING

USDKZT, CPI, and NBK rate, % Inflation risks in check, but subject to FX developments

The high oil price and improving current account did not prevent 9% YTD depreciation of KZT to USD, as the tenge is now allowed to float in line with trade partners’ currencies. Thanks to the downward pressure on gasoline prices due to higher supply, this did not translate into higher local inflationary pressure, with CPI decelerating to 5.3% YoY as of October, at the lower bound of the target range of 5-7%. Nevertheless, the NBK (central bank) decided to hike the key rate from 9.0% to 9.25% citing the upside risks to the FX and CPI from external uncertainties. As is the case for Russia, we see stable FX and CPI within the guidelines for the mid-term, with possible upside risks to our forecasts.

Source: CEIC, ING

-3%

0%

3%

6%

9%

12%

15%

-10%

0%

10%

20%

30%

Domestic demand InventoriesNet exports GDP, %YoY (rhs)

40

50

60

70

80

90

100

110

-7%-6%-5%-4%-3%-2%-1%0%1%2%3%

2013 2014 2015 2016 2017 2018F

Current account, % GDP Fiscal balance, % GDPBrent, $/bbl (rhs)

% GDP

$/bbl

3

6

9

12

15

18

140

180

220

260

300

340

380

USD/KZT, aop (lhs) CPI, %YoY (rhs) Key rate, % (rhs)

USD/KZT %



32

Kazakhstan 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018F 2019F 2020F

Activity Real GDP (% YoY) 3.3 1.2 7.3 7.4 4.8 6.0 4.2 1.2 1.1 4.1 3.9 3.5 3.4 Private consumption (% YoY) 7.8 0.6 11.8 12.0 10.1 10.6 1.1 1.8 1.2 1.5 3.0 3.5 3.3 Government consumption (% YoY) 2.6 1.0 2.7 11.9 13.5 1.7 9.8 2.4 2.3 2.1 2.4 2.2 2.0 Investment (% YoY) 1.0 -0.8 3.8 3.4 9.9 5.5 4.4 4.2 3.0 4.0 4.5 5.0 4.7 Industrial production (% YoY) 2.6 2.7 9.6 3.8 0.7 2.5 0.3 -1.6 -1.1 7.3 4.5 4.0 3.5 Unemployment rate (year-end, %) 6.6 6.6 5.8 5.4 5.3 5.2 5.0 5.1 5.0 4.9 4.8 4.8 4.8 Nominal GDP (KZTbn) 16,053 17,008 21,816 28,243 31,015 35,999 39,676 40,884 46,971 53,101 57,417 63,170 69,172 Nominal GDP (€bn) 91 82 110 138 161 178 168 167 125 143 145 147 150 Nominal GDP (US$bn) 133 115 148 193 208 236 221 183 137 163 168 178 192 GDP per capita (US$) 8,348 7,104 9,005 11,550 12,297 13,781 12,699 10,365 7,667 8,965 9,349 9,646 10,095 Gross domestic saving (% of GDP) 45.4 40.8 43.8 47.3 43.5 39.9 40.8 34.6 33.8 35.5 n/a n/a n/a

Prices CPI (average, % YoY) 17.3 7.3 7.1 8.3 5.1 5.8 6.7 6.6 14.7 7.4 6.3 6.3 5.9 CPI (year-end, % YoY) 9.5 6.2 7.8 7.4 6.0 4.8 7.4 13.6 8.5 7.1 6.0 6.0 5.5 Wage rates (nominal, % YoY) 16.4 10.9 14.7 15.9 13.5 6.8 10.6 5.2 10.0 6.0 8.0 6.8 6.4

Fiscal balance (% of GDP) State* budget balance -2.1 -2.9 -2.4 -2.0 -2.9 -1.9 -2.7 -2.2 -1.6 -2.7 -1.6 -2.1 -1.5 State* budget primary balance -1.7 -2.5 -2.0 -1.7 -2.1 -1.4 -2.1 -1.5 -0.8 -2.1 -0.6 -1.0 -0.5 Total public debt 8.3 12.3 14.4 11.6 12.3 12.3 14.3 22.1 24.3 26.0 26.1 25.0 24.0

External balance Exports (US$bn) 72.0 43.9 61.4 85.2 86.9 85.6 80.3 46.5 37.3 49.5 70.0 62.0 64.0 Imports (US$bn) 38.4 28.9 32.9 40.3 48.8 50.8 44.1 33.8 28.1 32.1 34.0 35.0 36.0 Trade balance (US$bn) 33.6 15.0 28.5 44.8 38.1 34.8 36.2 12.7 9.2 17.3 36.0 27.0 28.0 Trade balance (% of GDP) 25.2 13.0 19.3 23.3 18.3 14.7 16.4 6.9 6.7 10.7 21.4 15.1 14.6 Current account balance (US$bn) 6.3 -4.1 1.4 10.2 1.1 1.3 6.1 -5.1 -8.9 -5.4 -1.0 -4.0 -2.0 Current account balance (% of GDP) 4.7 -3.6 0.9 5.3 0.5 0.5 2.8 -2.8 -6.5 -3.3 -0.6 -2.2 -1.0 Net FDI (US$bn) 13.1 10.1 3.7 8.6 11.9 8.0 4.6 3.1 13.4 3.7 8.0 6.0 9.0 Net FDI (% of GDP) 9.8 8.8 2.5 4.5 5.7 3.4 2.1 1.7 9.8 2.3 4.8 3.4 4.7 Current account balance plus FDI (% of GDP) 14.5 5.2 3.4 9.8 6.2 3.9 4.9 -1.1 3.3 -1.0 4.2 1.1 3.6 Foreign exchange reserves ex gold (US$bn) 17.9 20.6 25.2 25.2 22.1 19.2 21.8 20.3 20.1 18.2 17.0 18.0 19.0 Import cover (months of merchandise imports) 5.6 8.5 9.2 7.5 5.4 4.5 5.9 7.2 8.6 6.8 6.0 6.2 6.3

Debt indicators Gross external debt (US$bn) 107.9 112.9 118.2 125.3 136.9 150.0 157.6 153.4 163.3 167.2 175.0 180.0 185.0 Gross external debt (% of GDP) 81 98 80 65 66 63 71 84 119 103 104 101 96 Gross external debt (% of exports) 150 257 193 147 157 175 196 330 438 338 250 290 289 Lending to corporates/households (% of GDP) 46.5 44.9 34.8 31.1 32.1 31.4 30.5 31.0 27.1 24.4 25.5 25.5 25.6

Interest & exchange rates Central bank key rate (year-end, %) 10.00 7.00 7.00 7.50 5.50 5.50 5.50 16.00 12.00 10.25 9.25 8.00 7.00 Broad money supply (average, % YoY) 35.4 19.5 13.3 15.0 7.9 10.2 10.4 33.8 15.6 -1.7 1.5 3.0 5.0 3m interest rate (KazPrime, average, %) 8.5 8.3 4.1 1.8 2.5 6.5 7.1 10.4 15.5 11.8 10.4 10.0 8.3 3m interest rate spread over US$-Libor (ppt) 397 715 325 37 197 628 693 1042 1577 1208 1072 1025 823 2yr yield (average, %) n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a 10yr yield (average, %) n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a USD/KZT exchange rate (year-end) 120.9 148.4 147.4 148.5 150.4 154.3 182.4 340.6 333.7 332.9 350 370 350 USD/KZT exchange rate (average) 120.3 147.8 147.4 146.7 149.2 152.2 179.4 223.2 341.9 326.2 341 354 360 EUR/KZT exchange rate (year-end) 169.2 212.2 197.5 193.0 198.6 211.3 220.7 371.3 350.4 399.4 403 463 455 EUR/KZT exchange rate (average) 176.9 206.9 197.5 205.3 192.4 202.4 236.8 245.5 376.1 371.9 396 428 461 Brent oil price (annual average, US$/bbl) 59 94 36 78 96 111 113 108 45 55 75 66 69

*State budget does not include the balance of NFRK, the state oil fund Source: National sources, ING estimates


Real GDP (% YoY) 4.3 4.0 4.1 4.1 3.8 3.5 3.2 3.4 3.6 3.8 3.7 3.5 3.3 CPI (eop, % YoY) 7.1 7.1 6.6 5.9 6.1 6.0 6.5 6.5 6.5 6.0 6.3 6.0 5.7 Central bank key rate (eop, %) 10.25 10.25 9.50 9.00 9.00 9.25 9.25 9.25 9.25 8.00 7.75 7.50 7.25 3m interest rate (eop, %) 11.25 11.25 10.50 10.00 10.00 10.25 10.25 10.25 10.25 9.00 8.75 8.50 8.25 10yr yield (eop, %) n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a USD/KZT exchange rate (eop) 340.7 332.9 318.7 341.3 363 350 340 350 360 370 365 360 355 EUR/KZT exchange rate (eop) 408.8 399.4 382.5 399.3 418 403 391 413 432 463 460 457 454



33

Poland Rafal Benecki, Chief Economist Poland


Real GDP (% YoY) 5.1 4.9 4.2 3.9 3.5 4.8 3.5 CPI (% YoY)* 2.0 1.9 1.7 2.8 3.0 1.7 2.7 Policy interest rate (eop, %) 1.5 1.5 1.5 1.5 1.5 1.50 1.50 3m interest rate (%)* 1.70 1.72 1.73 1.73 1.73 1.71 1.73 10yr yield (%)* 3.22 3.24 3.20 3.23 3.26 3.24 3.26 USD/PLN* 3.82 3.71 3.74 3.69 3.60 3.67 3.52 EUR/PLN* 4.36 4.27 4.30 4.24 4.25 4.26 4.27


Activity Presidential: 2020 S&P A- A Fiscal Tighter Parliamentary: 2019 Moody’s A2 A2 Monetary Neutral Local: 2022 Fitch A- A-

A second surprise in a row, with lower fiscal deficit and limited external vulnerability, secures Poland’s position as a stable bay among EMs. In tandem with higher hike expectations, this improved data calls for PLN resilience to negative EM sentiment. We look for €/PLN close to 4.30 in 4Q18. POLGBs may slightly underperform core markets in 2019. Of PLN20bn foreign-held bonds maturing next year some PLN10bn are unlikely to be reinvested, as POLGBs seem expensive. Moreover, new debt issuance in 2019 is slightly higher than in 2018 (PLN41bn vs PLN38bn). External factors are a risk as well (EM tensions caused by the Fed, a strong US$ and Trump extending his protectionist policy). 2019 is election year, but we believe 2020 could be burdened with any spending pledges.


GDP structure (% YoY) Macro digest

The Polish economy has already passed its peak (+5%YoY in 1H18) in this cycle. While 3Q18 growth is likely to remain close to 5%YoY, we see growth moderation ahead – from 4.8%YoY in 2018 to 4.2%YoY in 4Q18 and 3.5%YoY next year. Weaker growth prospects chiefly reflect slowing consumption growth and increasingly more negative base effects on investments, as well as uncertain sentiment abroad.

While industrial output showed no tangible sign of slowdown among export-oriented branches in 3Q18, the leading indicators suggest that producers already see a slump in new orders (both domestic and export). Moreover, Polish PMIs showed surprising weakness compared to other CEEs with new export orders below 50pts, close to the 2014 bottom.

Therefore the slowdown in 4Q18 should be mostly visible in industrial production, transportation and construction. Manufacturers suffer from lower external demand. We expect industrial production to decelerate from 6% YoY in 3Q18 to 3% in 4Q18 chiefly on slowing activity in exporting divisions (eg, automotive, machinery, furniture). On the other hand, problems within the construction sector are domestically driven. The profitability of companies has deteriorated in recent quarters (despite strong public investments) due to double-digit wage growth and higher material costs.

We expect investments to remain quite strong in 2019 (+6% YoY, similar to 2018), chiefly driven by EU co-financed projects. Private outlays are likely to remain limited – corporate surveys signal weakening planned outlays in key sectors (manufacturing and construction). Moreover, weak PMIs signal delays to major projects.

Labour market pressures are moderating. Despite workforce shortages, companies report falling wage hike plans (the NBP survey reveals). Therefore we expect enterprise sector wage growth to end 2018 close to 7% YoY. Stable wage growth is unlikely to maintain household consumption growth at current levels – in 2019 we expect it to slow to 3.7 %YoY down from 4.6% YoY this year.

We see a CPI recovery in 1H19 to 3% YoY, but mostly driven by regulatory and external factors (more in the CPI box below). Therefore, we expect the MPC to keep rates flat until 2021. The current council sees the neutral rate lower than previous levels (according to our estimates based on the Taylor/Ball rule, 2% vs 2.5-3.5%). Moreover, the CPI acceleration will coincide with a more pessimistic GDP outlook – an inflation peak of about 3% YoY in mid-2019 should not force the MPC to act as the council will risk a late cycle hike.

Source: GUS, ING

Wage pressure is fading

Source: GUS, ING

Private companies cut their investments plans

Source: GUS, NBP

-4

-2

0

2

4

6

2016 2017 2018 2019Priv. Consumption Pub. consumption Fixed InvestmentsInventories Net exports GDP

0

10

20

30

40

50

0

5

10

15

2007 2009 2011 2013 2015 2017Wages - Enterprise Sector (%YoY, SA) (lhs)NBP survey: % of enterprises planning wage increase (SA)

-1.0

-0.5

0.0

0.5

1.0

-20

-10

0

10

20

2012 2013 2014 2015 2016 2017 2018Investments - big companies (PLNmld, %YoY)NBP survey: New investments plans (change - YoY)NBP survey: Cont. investments (change - YoY)


34

Warsaw, +48 22 820 4696 [email protected]

CPI – realisation of the NBP target (%YoY) CPI to peak at 3%YoY in 2019

CPI was slightly below 2% YoY in 3Q18. We expect a fall to the lower boundary of the NBP target in 4Q (1.5% YoY) due to stagnant core CPI and negative base effects on food and fuel prices.

In 2019 we see CPI peaking around 3% YoY, but with a different structure than expected, ie, less labour cost, more impact of energy. The higher price dynamic reflects rising electricity prices both retail (according to the Ministry of Energy retail tariffs are to rise by 5%YoY) and wholesale. The latter should affect PPI, which passes to core CPI with a 2Q-3Q lag, adding some 0.15ppt to annual growth. Moreover, we anticipate higher food prices (mostly vegetables, meat) caused by a heatwave this summer. Methodological changes (in the clothing & footwear category) should add a further 0.2ppt to core CPI.

Source: GUS, ING forecasts

Central budget deficit (rolling 12-month sum) (PLNbn) Government deficit to rise from 1.0% to 1.5% GDP in 2019

We expect the general government deficit in 2019 to reach 1.5% GDP, more than in 2017 (1.4% GDP) and 2018 (we expect 1.0% GDP). We believe that the GDP slowdown and the change of its structure to more investment based will cause an erosion of the tax base. Also space for further tax tightening is, in our opinion, limited.

The IMF recently revised its forecast for the 2018 general government deficit down to 0.3% GDP. The MoF unofficially hinted at a similar level. We see 1.0% GDP, as the central government has no incentive to cut expenditures and local governments should raise spending due to high EU co-founded investment. Consequently, we look for net POLGB issuance next year of around PLN41bn (up from PLN38bn in 2018).

Source: MinFIn

Double-digit growth of services export related to SSC Modest C/A deterioration

The 12m C/A deficit in 1H18 hovered around 0.2% of GDP, above our expectations. The GDP growth driven by strong domestic demand and higher energy commodities’ prices resulted in a fall in the goods trade balance to negative territory (on average a €570m deficit/per quarter in 1H18 vs a €350m surplus in 2017). However, such deterioration was offset by further expansion of services exports – the surplus increased from €4.4bn in 2017 to €5.5bn in 1H18.

Looking ahead we expect stagnation of the C/A gap at the current level in 2H18 and 2019. The more upbeat growth in investments should further encourage imports. Again Poland should offset these changes with stronger export of services and a doubling of inflows of EU funds.

SSC stands for shared services centres Source: Eurostat

Political support poll October 2018 Political outlook

The ruling PiS/ECR won regional elections with 34.3% support (likely preventing costly pre-election pledges) over a coalition of key opposition parties KO (EPP and ALDE 27.1%), PSL (EPP 12.1%) and SLD (S&D 6.6%). There are two key elections in 2019 – for the European (May 2019) and the local parliament (2H19). The results are likely to hinge on (the higher the turnout, the stronger the support for the opposition). Most likely PiS will lose its single-party majority in parliament and will be forced into a coalition.

The clash with the European Commission has moved to the European Court of Justice. We expect the government to postpone the solution, risking limited financial penalties. The topic is no longer followed by markets due to low chance of a meaningful sanction.

Source: Blog Wyborczy

-2

-1

0

1

2

3

4

5

2012 2013 2014 2015 2016 2017 2018 2019

NBP Inflation target CPI (%YoY) core CPI (%YoY)

f'cast

-30

-10

10

30

50

2008 2010 2012 2014 2016 2018Services (Total, %YoY) TechnicalICT & Telco Management


35

Poland Strategy

FX – spot vs forward and INGF FX strategy

In 3Q18 €/PLN entered a narrow horizontal trend around 4,30. The zloty proved little affected by external developments, likely due to strong domestic macro and expectations for the NBP to keep a stable rate disparity against the ECB. According to the short-term ING relative value model, the zloty remains undervalued against the euro (a position held since 2Q18).

We expect the €/PLN rate to remain close 4.30 for the remainder of 2018, chiefly reflecting the negative international environment for emerging markets. We also see upward €/PLN potential as limited (with the 4.40 resistance hard to break). Poland’s vulnerability to external shocks is limited due to relatively low hard currency debt and trade links outside the EU. Moreover, markets are likely to continue to price an excessively high NBP rate path.

The Polish currency should gain in 1H19 should euro area weakness prove transitory. Poland is expected to maintain a relatively solid growth momentum compared to core EU economies, which, in tandem with rising CPI, should keep market NBP rate pricing relatively high. The scope for a €/PLN decline is limited (4.20-4.25) in our view, as we expect the Polish MPC to hold rates flat until 2021.

We are less optimistic for 2H19 – we see €/PLN closer to 4.30-4.35. In the second half of 2019, GDP is expected to substantially decelerate and we cannot exclude some political tensions (or expectations for a substantial fiscal loosening) ahead of the 2019 parliamentary elections in Poland.


2018 PLN swap performance – falling hike bets in Oct

Source: Macrobond

Local curve (%)

Source: Bloomberg

POLGBs 2018 holder change – local banks ceased buying

Source: Ministry of Finance


36

Poland 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018F 2019F 2020F

Activity Real GDP (% YoY) 3.9 2.6 3.7 5.0 1.6 1.4 3.3 3.8 3.1 4.8 4.8 3.5 2.7 Private consumption (% YoY) 6.1 3.3 2.5 3.3 0.8 0.3 2.6 3.0 3.9 4.9 4.6 3.7 2.6 Government consumption (% YoY) 5.1 3.6 3.3 -1.8 -0.4 2.2 4.0 2.1 2.1 3.3 3.9 2.8 2.8 Investment (% YoY) 8.4 -1.9 -0.4 8.8 -1.8 -1.1 10.0 6.1 -8.2 3.9 7.2 6.2 3.0 Industrial production (% YoY) 3.9 -3.6 11.0 7.2 1.4 2.3 3.4 4.9 3.0 6.5 5.3 3.8 3.6 Unemployment rate (year-end, %) 9.5 12.1 12.4 12.5 13.4 13.4 11.4 9.7 8.2 6.6 5.9 5.7 6.2 Nominal GDP (PLNbn) 1,277 1,362 1,445 1,567 1,629 1,656 1,720 1,799 1,858 1,982 2,110 2,237 2,352 Nominal GDP (€bn) 363 315 362 380 389 395 411 430 425 467 495 525 547 Nominal GDP (US$bn) 534 441 485 532 502 525 542 473 467 532 574 635 700 GDP per capita (US$) 13,928 11,484 12,503 13,793 13,071 13,689 14,234 12,475 12,326 13,750 15,378 17,035 18,955 Gross domestic saving (% of GDP) 13.6 16.3 14.9 16.2 17.7 20.5 20.5 23.7 23.8 24.7 24.9 24.5 24.6

Prices CPI (average, % YoY) 4.2 3.4 2.6 4.3 3.7 0.9 0.0 -0.9 -0.6 2.0 1.7 2.7 2.8 CPI (year-end, % YoY) 3.3 3.5 3.1 4.6 2.4 0.7 -1.0 -0.5 0.8 2.1 1.7 2.4 2.7 Wage rates (nominal, % YoY) 10.5 4.2 3.6 4.9 3.5 2.6 3.8 3.5 4.1 5.7 7.4 7.5 6.4

Fiscal balance (% of GDP) Consolidated government balance -3.6 -7.3 -7.3 -4.8 -3.7 -4.1 -3.7 -2.7 -2.2 -1.4 -1.0 -1.5 -1.9 Consolidated primary balance -1.5 -4.8 -4.9 -2.3 -1.1 -1.6 -1.7 -0.9 -0.6 -0.1 0.0 0.1 0.2 Total public debt 46.3 49.4 53.1 54.1 53.7 55.7 50.4 51.3 54.2 50.6 49.1 48.4 48.3

External balance Exports (€bn) 113.0 95.4 118.1 132.4 141.0 149.1 158.6 172.2 177.5 201.9 211.8 222.3 233.7 Imports (€bn) 136.5 103.1 129.1 145.7 149.2 149.4 161.9 170.0 174.6 200.5 211.7 224.5 237.1 Trade balance (€bn) -23.5 -7.7 -10.9 -13.3 -8.1 -0.3 -3.3 2.2 2.9 1.4 0.2 -2.2 -3.4 Trade balance (% of GDP) -6.5 -2.5 -3.0 -3.5 -2.1 -0.1 -0.8 0.5 0.7 0.3 0.0 -0.4 -0.6 Current account balance (€bn) -24.3 -12.8 -19.5 -19.7 -14.5 -5.1 -8.6 -2.4 -2.2 0.7 0.6 -1.0 0.8 Current account balance (% of GDP) -6.7 -4.1 -5.4 -5.2 -3.7 -1.3 -2.1 -0.6 -0.5 0.1 0.1 -0.2 0.1 Net FDI (€bn) 6.7 5.8 6.5 9.8 4.7 3.2 9.8 9.1 3.9 5.6 8.1 10.1 11.1 Net FDI (% of GDP) 1.9 1.9 1.8 2.6 1.2 0.8 2.4 2.1 0.9 1.2 1.6 1.9 2.0 Current account balance plus FDI (% of GDP) -4.9 -2.2 -3.6 -2.6 -2.5 -0.5 0.3 1.6 0.4 1.3 1.8 1.7 2.2 Foreign exchange reserves ex gold (€bn) 44.7 55.2 70.0 75.6 82.5 77.0 82.7 87.2 108.1 94.5 102.4 97.2 99.2 Import cover (months of merchandise imports) 3.9 6.4 6.5 6.2 6.6 6.2 6.1 6.2 7.4 5.7 5.8 6.5 6.5


Interest & exchange rates Central bank key rate (year-end %) 5.00 3.50 3.50 4.50 4.25 2.50 2.00 1.50 1.50 1.50 1.50 1.50 1.50 Broad money supply (average, % YoY) 18.6 8.1 8.8 12.5 4.5 6.2 8.2 9.1 9.6 4.6 6.4 6.4 6.1 3m interest rate (Wibor, average, %) 6.35 4.34 3.93 4.58 4.87 2.98 2.49 1.74 1.70 1.73 1.71 1.73 1.73 3m interest rate spread over Euribor (ppt) 346 364 293 322 468 269 241 187 202 205 203 188 163 2yr yield (average, %) 5.39 5.22 4.77 4.85 3.14 3.05 1.79 1.62 2.03 1.72 1.57 1.57 1.33 10yr yield (average, %) 6.06 6.13 5.80 5.98 4.94 4.09 3.46 2.69 3.08 3.46 3.24 3.26 3.23 USD/PLN exchange rate (year-end) 2.97 2.87 2.97 3.43 3.09 3.03 3.53 3.91 4.21 3.48 3.74 3.44 3.31 USD/PLN exchange rate (average) 2.39 3.09 2.98 2.94 3.24 3.16 3.17 3.80 3.98 3.72 3.67 3.52 3.36 EUR/PLN exchange rate (year-end) 4.15 4.10 3.98 4.46 4.07 4.15 4.27 4.26 4.42 4.17 4.30 4.30 4.30 EUR/PLN exchange rate (average) 3.52 4.33 3.99 4.12 4.18 4.20 4.19 4.18 4.38 4.24 4.26 4.27 4.30



Real GDP (% YoY) 5.2 4.9 5.2 5.1 4.9 4.2 3.9 3.5 3.4 3.3 3.2 2.9 2.7 CPI (eop, % YoY) 2.2 2.1 1.3 2.0 1.9 1.7 2.8 3.0 2.7 2.4 2.6 2.6 3.0 Central bank key rate (eop, %) 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 3m interest rate (eop, %) 1.73 1.72 1.70 1.70 1.72 1.73 1.73 1.73 1.73 1.73 1.73 1.73 1.73 10yr yield (eop, %) 3.37 3.30 3.18 3.22 3.24 3.20 3.23 3.26 3.28 3.31 3.27 3.23 3.19 USD/PLN exchange rate (eop) 3.86 3.97 3.95 3.82 3.71 3.74 3.69 3.60 3.56 3.44 3.41 3.39 3.36 EUR/PLN exchange rate (eop) 4.31 4.17 4.21 4.36 4.27 4.30 4.24 4.25 4.27 4.30 4.30 4.30 4.30



37

Romania Ciprian Dascalu, Chief Economist, Romania

Forecast summary Country strategy: flashing red lights 2Q18 3Q18 4Q18F 1Q19F 2Q19F 2018F 2019F

Real GDP (% YoY)* 4.1 3.2 3.9 4.8 3.9 3.8 4.0 CPI (% YoY)* 5.4 5.0 3.9 3.7 3.5 4.7 3.6 Central bank key rate (%)* 2.50 2.50 2.50 2.75 3.00 2.50 3.25 3m interest rate (%)* 3.15 3.17 3.20 3.40 3.60 2.90 3.61 10yr yield (%)* 5.21 4.77 5.10 5.20 5.30 4.89 5.30 USD/RON* 3.98 4.06 4.09 4.06 3.98 4.01 3.89 EUR/RON* 4.66 4.66 4.70 4.67 4.70 4.66 4.71


Activity Presidential: Nov 2019 S&P BBB- BBB- Fiscal Neutral Parliamentary: Dec 2020 Moody’s Baa3 Baa3 Monetary Tighter Local: Jun 2020 Fitch BBB- BBB-

Three consecutive years of 3.0% of GDP budget shortfall, despite a strong GDP growth backdrop and accommodative monetary policy stance, led to twin deficits flashing red on investors’ radar. The NBR reaction was adequate, though a bit tardy, but tighter monetary policy stance is unlikely to be the panacea for bringing the economy back on track. With a heavy election calendar ahead, fiscal consolidation is doubtful. Risks to structural reforms are tilted to a rollback rather than acceleration. Absent an external shock, growth is likely to be supported by external demand, though limited by structural issues. The inflation outlook should stay skewed to the upside and external imbalances mostly likely will continue to widen. All in all, not an imminent disaster but vulnerable to any surprises.


Consumers running out of confidence Macro digest: lower cruising speed

GDP growth slowed to 4.1% YoY in 1H18 vs 6.9% YoY in 2017. The new cruising speed for economic expansion is within the range of potential growth estimates. The main driver for the shift into lower gear was household consumption, with 6.3ppt of the previous year’s GDP growth. Private consumption contracted in 4Q17 and 1Q18 on a sequential basis, in line with the sharp fall in consumer confidence. The main factors cited for softer consumer morale include the outlook for the financial, savings and economic situation over the next twelve months. Job prospects remained solid. This is likely explained by a number of factors: uncertainties on net wages in the private sector after the government shifted part of the social contribution tax from employer to employee, sharp monetary policy tightening of over 200bp in less than a year, higher inflation biting into disposable income, a somewhat weaker leu hitting expectations and fading fiscal stimulus. Private demand recovered in 2Q18 as worries on the impact on net wages from social contribution transfer subsided and consumers adjusted to the new interest rate environment. Consumer confidence recovered further in 3Q18, to a one year high in September. Nevertheless, high frequency hard data such as retail sales are not pointing to an acceleration of consumption in 3Q. Investments, after a 2017 rebound, contracted in the first two quarters of 2018 on a sequential basis and the outlook is not brightening due to labour market constraints.

On the supply side, industry was hit by the soft patch in Germany/Western Europe at the start of the year, but recovered a bit in 2Q. While manufacturing confidence improved further in 3Q, production slowed in the first two months of the quarter. Construction was hit by higher interest rates on the residential segment and low public investments due to budget constraints. Services, the main contributor to GDP growth, contracted in the second quarter on sequential basis and confidence worsened further in the third quarter - the segment is exposed the most to a slowdown in disposable income growth and changes in consumer morale.

GDP growth is likely to be in a 3.5-4.0% range over the next couple of years given the limited to no-room for fiscal stimulus, monetary policy heading towards neutral stance, scarce labour resources, weakening competitiveness and higher cost of capital. On the latter, a shrinking positive output gap and the NBR deploying macro-prudential measures to tighten policy stance mean that the bulk of the rate hikes are likely behind us. However, the lack of structural reform drive is likely to lead to lower potential growth rates ahead.

Source: NIS, ING

GDP growth acceleration on inventories

Source: NIS, ING

4Q17: sharpest QoQ drop in consumer confidence post-GFC

Source: EC, NIS, ING

2.3 3.83.3

4.3 3.4 3.8

4.04.3

6.0

4.3 4.8 5.7 6.1

8.86.7

4.0 4.1

-5

-2

1

4

7

10

2Q14 4Q14 2Q15 4Q15 2Q16 4Q16 2Q17 4Q17 2Q18

Private consumption Public consumptionFixed investment OthersNet exports GDP (%YoY)

-4-3-2-1012345

1Q17 2Q17 3Q17 4Q17 1Q18 2Q18

Others Private consumptionPublic consumption Fixed investmentNet exports GDP (QoQ%)

-10

-5

0

5

10

15

75

85

95

105

115

Economic Sentiment Indicator (3m avg)

GDP excluding agriculture (%YoY, rhs)



38

Bucharest, +40 31 406 89 90 [email protected]

Rigid spending limiting fiscal leeway Trade-off between political cost and EDP commitment

While revenues have been broadly in line with expectations, ballooning expenditures make it increasingly difficult for the government to kick the can down the road again in 2019. For the current year a bit of fiscal patchwork here and there - by cutting investment expenses, lowering co-financing needs for EU funds, special dividends from SOEs and revising other spending plans clustered usually into the year-end - will likely be enough to stay within the deficit of 3% of GDP. Nevertheless, going forward, due to an increasing share of rigid state spending, the commitment to the 3.0% of GDP budget deficit limit could become a trade-off between political costs associated with this ‘fiscal rule’ and those arising from entering the excessive deficit procedure (EDP).

Source: MinFin, ING

New majority? A lot can happen in two years… Heavy election calendar ahead: no breaks on spending

Four elections in two years means heightened uncertainty. The European (May 2019) and presidential (November 2019) elections are unlikely to lead to enhanced government electoral spending. The former is more important for new parties like USR and MRI looking for electoral confirmation. For the presidency, incumbent Iohannis is the only candidate confirmed so far. The 2020 elections are much more important for the current government coalition and its main party, the PSD, which has already put forward a timeline for increasing pensions with the largest hike set for Sep-20, just ahead of general elections due in Dec-20. Local elections in Jun-20 could mean doubling up on spending pledges. Results at local ballots are usually indicative for the outcome at general elections.

Source: IMAS (September-2018)

Widening C/A deficit, weaker financing structure Correcting the C/A: choose your poison

The persistent deterioration in C/A could become the Achilles’ heel for the Romanian economy as correcting the imbalances seems to require more than just an economic slowdown. With FDIs covering only 48% of the C/A deficit as of Aug-18 (from 82% in 2017), the financing mix is clearly suboptimal. The trade balance is mainly to blame, but levelling off surpluses on the services balance and low EU funds absorption give, as well, little reason to be optimistic about an upcoming rebalancing. Some envisaged nominal depreciation of the leu in the next twelve months would help, but without a meaningful fiscal consolidation, it is unlikely to see the deterioration trend reversing. Hence, the balance between a “soft adjustment” and a “hard correction” starts to be tilted towards the latter.

Source: NBR, ING

Most of the tightening behind us, but mind the FX… …stability with minimum rate hikes, liquidity management

After embarking on an aggressive tightening cycle towards the end of 2017 and beginning of 2018, the NBR has taken a pause from hiking in the second part of 2018 to assess the impact of its previous actions. The hiking cycle could be resumed early in 2019, as headline inflation remains stubbornly high, with the NBR likely to miss its inflation target of 2.5% ±1ppt this year. Meanwhile, tightening has also been delivered through nominal FX stability which strengthened the Romanian leu compared to its regional peers, but also through recently approved macro-prudential measures aimed at capping the debt-to-income ratio for retail borrowers. These will likely help to minimise the number of rate hikes in 2019 and thus reach a lower terminal key rate.

Source: NBR, ING

55

69

81 80

6965 66 67 65

70

7779

5055606570758085 (wage envelope + social

benefits) / (fiscal revenues + social contributions)

PSD28%

ALDE11%

PNL27%

USR10%

MRI10%

UDMR6%

Others (<5%)8%

0%50%100%150%200%250%300%

-3.5%-3.0%-2.5%-2.0%-1.5%-1.0%-0.5%0.0%

C/A as % of GDP FDIs as % of C/A (rhs)

0

1

2

3

4

-5

0

5

10

15

20

Sep-14 Sep-15 Sep-16 Sep-17 Sep-18 Sep-19

Liquidity position (RON/bn/day, avg, lhs)3M ROBOR (% avg, rhs)Key rate (%, rhs)

ING forecast



39

Romania Strategy

FX – spot vs forward and INGF FX strategy: Carry versus fundamentals

Despite EM headwinds, the RON has been remarkably stable. Having the highest FX pass-through in the CEE and the widest overshooting of the inflation target band, the NBR fended-off RON weakening pressure via FX interventions and money market liquidity management. FX stability was likely part of the NBR strategy to contain inflation expectations. Most REER metrics point to deteriorating competitiveness. The outperformance versus CEE peers, with Romania running trade deficits with most of its neighbours, points to some catching up over the medium-term. While we agree that the depreciation is not a panacea, it would likely be part of the adjustment.

A heavy election calendar ahead while running fiscal deficits to the EDP limit points to RON vulnerabilities on the back of potential capital outflows given the unhealthy C/A financing. As inflation is expected to converge towards the target band, NBR might allow gradual RON weakness, but the timing is difficult to call. Short-lived liquidity squeezes are more likely than FX interventions to rein in FX. High media coverage, with a negative bias, of even limited day-to-day EUR/RON volatility and, more recently, to ROBOR rates used for indexing floating rate loans, is likely making NBR Board members more cautious, especially if they seek a new term from the Parliament after the current one ends in October 2019. Assuming an absorption rate of EU funds similar to the previous exercise - which is likely to lead to accumulation of FX reserves - and that the government is not cut-off from international markets to finance the C/A shortfall, stability is likely to prevail in the EUR/RON market.


ULC REER (2005=100): RON in line with peers

Source: EC, ING

Local curve (%)

Source: Reuters, ING

Stable inflows from private pensions at risk?

Source: MinFin, ING

4.4

4.5

4.6

4.7

4.8

4.9

5.0

Dec-16 Jun-17 Dec-17 Jun-18 Dec-18 Jun-19 Dec-19

EURO/RON INGF Mkt forward Mkt consesnsus

60

80

100

120

140

BGN CZK HUF PLN RON

0

20

40

60

80

100

120

4.0

4.5

5.0

5.5

Mar-18 Jun-18 Sep-18 Dec-18 Mar-19 Jun-19 Sep-19 Dec-19

3Y/10Y (spread, bp, rhs) 10Y (yield, %, lhs)

INGF

0

20

40

60

Aug-13 Aug-14 Aug-15 Aug-16 Aug-17 Aug-18

International investors Pillar II pension funds Banks


40

Romania 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018F 2019F 2020F

Activity Real GDP (% YoY) 8.3 -5.9 -2.8 2.0 2.1 3.5 3.4 3.9 4.8 6.9 3.8 4.0 3.7 Private consumption (% YoY) 7.8 -8.4 -3.4 1.3 1.9 1.2 4.5 5.8 8.0 9.9 3.0 4.5 4.4 Government consumption (% YoY) 6.9 3.2 -4.8 -1.2 7.5 -2.9 3.5 -0.3 2.2 -0.5 1.7 1.3 3.3 Investment (% YoY) 17.6 -35.8 0.1 6.1 3.1 -5.6 3.3 7.5 -2.0 4.7 -2.5 0.8 1.3 Industrial production (% YoY) 2.9 -5.4 4.9 8.1 3.0 7.7 6.4 2.7 3.1 8.7 5.5 4.7 2.4 Unemployment rate (year-end, %) 5.6 6.6 7.0 7.1 6.8 7.1 6.8 6.8 5.9 4.9 4.2 4.0 4.0 Nominal GDP (RONbn) 538 526 528 559 594 635 669 713 765 859 940 1020 1090 Nominal GDP (€bn) 146 124 125 132 133 144 150 160 170 188 202 217 229 Nominal GDP (US$bn) 215 174 168 185 172 191 199 176 187 214 234 261 292 GDP per capita (US$) 10,200 8,200 8,300 9,200 8,500 9,600 10,000 9,000 9,500 11,000 12,000 13,400 15,100 Gross domestic saving (% of GDP) 20.2 20.4 20.9 22.4 21.9 24.8 24.3 24.6 24.1 24.1 23.9 24.0 24.2

Prices CPI (average, % YoY) 7.8 5.6 6.1 5.8 3.3 4.0 1.1 -0.6 -1.6 1.3 4.7 3.6 3.3 CPI (year-end, % YoY) 6.3 4.8 8.0 3.1 5.0 1.6 0.8 -0.9 -0.5 3.3 3.9 3.4 3.3 Wage rates (nominal, % YoY) 23.8 8.8 2.5 5.0 5.0 5.0 5.3 8.4 12.8 14.2 12.9 11.0 9.4

Fiscal balance (% of GDP) Consolidated government balance -5.4 -9.2 -6.9 -5.4 -3.7 -2.1 -1.3 -0.8 -2.9 -2.9 -3.0 -3.0 -3.0 Consolidated primary balance -4.7 -7.7 -5.4 -3.8 -1.9 -0.4 0.3 0.8 -1.5 -1.6 -1.6 -2.0 -2.4 Total public debt 12.4 22.1 29.7 34.0 36.9 37.5 39.1 37.7 37.4 35.0 35.0 35.3 36.0

External balance Exports (€bn) 33.7 29.1 37.4 45.3 45.0 49.6 52.5 54.6 57.4 62.6 67.9 73.1 78.2 Imports (€bn) 57.1 38.9 46.9 54.9 54.6 55.3 58.6 63.0 67.4 75.6 81.8 88.9 95.5 Trade balance (€bn) -23.5 -9.9 -9.5 -9.7 -9.6 -5.8 -6.1 -8.4 -10.0 -12.9 -13.8 -15.8 -17.3 Trade balance (% of GDP) -16.1 -7.9 -7.5 -7.3 -7.2 -4.0 -4.0 -5.2 -5.9 -6.9 -6.8 -7.3 -7.6 Current account balance (€bn) -16.8 -5.8 -6.4 -6.6 -6.4 -1.5 -1.0 -2.0 -3.6 -6.0 -8.5 -10.4 -12.0 Current account balance (% of GDP) -11.5 -4.7 -5.1 -5.0 -4.8 -1.1 -0.7 -1.2 -2.1 -3.2 -4.2 -4.8 -5.2 Net FDI (€bn) 9.0 3.4 2.3 1.7 2.6 2.9 2.7 3.0 4.5 4.9 5.2 5.4 5.7 Net FDI (% of GDP) 6.2 2.8 1.8 1.3 1.9 2.0 1.8 1.8 2.6 2.6 2.6 2.5 2.5 Current account balance plus FDI (% of GDP) -5.3 -1.9 -3.3 -3.7 -2.9 1.0 1.1 0.6 0.6 -0.6 -1.6 -2.3 -2.7 Foreign exchange reserves ex gold (€bn) 26.2 28.3 32.4 33.2 31.2 32.5 32.2 32.2 34.2 33.5 35.5 39.5 43.5 Import cover (months of merchandise imports) 5.5 8.7 8.3 7.2 6.9 7.1 6.6 6.1 6.1 5.3 5.2 5.3 5.5


Interest & exchange rates Central bank key rate (year-end %) 10.25 8.00 6.25 6.00 5.25 4.00 2.75 1.75 1.75 1.75 2.50 3.25 3.25 Broad money supply (average, % YoY) 17.5 8.2 6.2 6.2 4.6 8.8 7.8 10.0 9.7 11.6 9.4 10.4 11.7 3m interest rate (Robor, average, %) 13.0 11.7 6.7 5.8 5.3 4.2 2.5 1.4 0.9 1.1 2.8 3.6 3.5 3m interest rate spread over Euribor (ppt) 8.5 10.6 5.9 4.4 4.8 4.0 2.3 1.4 1.2 1.5 3.1 3.8 3.5 3yr yield (average, %) 11.5 11.1 7.4 7.2 6.3 4.8 3.3 1.9 1.5 1.9 3.8 4.7 4.5 10yr yield (average, %) 8.7 9.8 7.2 7.4 6.7 5.3 4.6 3.5 3.3 3.9 4.7 5.3 5.2 USD/RON exchange rate (year-end) 2.85 2.96 3.20 3.32 3.36 3.27 3.70 4.15 4.32 3.88 4.09 3.80 3.65 USD/RON exchange rate (average) 2.51 3.03 3.14 3.03 3.45 3.32 3.37 4.04 4.08 4.01 4.01 3.90 3.73 EUR/RON exchange rate (year-end) 3.99 4.23 4.28 4.32 4.43 4.48 4.48 4.52 4.54 4.66 4.70 4.75 4.75 EUR/RON exchange rate (average) 3.68 4.24 4.21 4.24 4.46 4.42 4.44 4.45 4.49 4.57 4.66 4.71 4.77


Quarterly forecasts 3Q17 4Q17 1Q18 2Q18 3Q18 4Q18F 1Q19F 2Q19F 3Q19F 4Q19F 1Q20F 2Q20F 3Q20F

Real GDP (% YoY) 8.8 6.7 4.0 4.1 3.2 3.9 4.8 3.9 3.7 3.7 3.7 3.5 3.9 CPI (eop, % YoY) 1.8 3.3 5.0 5.4 5.0 3.9 3.7 3.5 3.7 3.4 3.4 3.2 3.2 Central bank key rate (eop, %) 1.75 1.75 2.25 2.50 2.50 2.50 2.75 3.00 3.25 3.25 3.25 3.50 3.50 3m interest rate (eop, %) 1.58 2.05 2.08 3.15 3.17 3.20 3.40 3.60 3.70 3.75 3.75 3.75 3.75 10yr yield (eop, %) 4.10 4.31 4.46 5.21 4.77 5.10 5.20 5.30 5.40 5.30 5.20 5.20 5.20 USD/RON exchange rate (eop) 3.83 3.88 3.88 3.98 4.06 4.09 4.06 3.98 3.93 3.80 3.75 3.74 3.75 EUR/RON exchange rate (eop) 4.60 4.66 4.66 4.66 4.66 4.70 4.67 4.70 4.72 4.75 4.72 4.75 4.80



41

Russia Dmitry Dolgin, Chief Economist, Russia & CIS

Forecast summary Country strategy 2Q18 3Q18 4Q18F 1Q19F 2Q19F 2018F 2019F

Real GDP (% YoY) 1.9 1.3 1.7 1.1 0.8 1.6 1.0 CPI (% YoY)* 2.3 3.4 4.0 5.2 5.7 2.9 5.3 Policy interest rate (eop, %) 7.25 7.50 7.50 7.50 7.50 7.50 7.50 3m interest rate (%)* 7.5 8.1 8.3 8.1 7.9 7.7 7.9 10yr yield (%)* 7.7 8.5 8.5 8.3 8.1 7.9 8.1 USD/RUB* 57.5 65.6 63.0 64.0 65.0 62.2 64.6 EUR/RUB* 67.3 75.4 72.5 73.6 76.7 72.2 78.2


Activity Presidential: Mar-24 S&P BBB- BBB Fiscal Tighter Parliamentary: Sep-21 Moody’s Ba1 Ba1 Monetary Tighter Local: Fitch BBB- BBB-

With elections and the football World Cup behind, Russia is struggling to regain growth momentum, which is a challenging task amid uncertainties with global trade and mounting foreign policy tensions. The monetary policy has to remain moderately tight mid-term amid accelerating CPI, and the budget policy remains focused on state savings accumulation – yet it might have to be eased eventually.

Local FX and FI should be following the global portfolio flows, suggesting a mildly positive outlook, yet subject to downside risks. The potential introduction of sanctions against the new Russian state debt is not yet priced into asset prices and poses a downside risk to our FX/FI outlook. However, we do not see Russia’s financial stability to be at any material risk.


GDP and key contributors (% YoY, ppt) Macro digest

GDP growth decelerated to 1.3% YoY in 3Q18 and 1.6% YoY in 9M18, which is at the bottom of the 1.5-2.0% potential growth rate. The slowdown reflects weaker consumer and producer activity. The contribution of local demand to growth is declining, reflecting the end of the electoral cycle, the end of the football World Cup, higher uncertainties related to external markets and foreign policy. The reliance on net exports is growing, with both fuel and non-fuel exports posting growth and imports under pressure of weakening domestic demand and 13% YTD RUB depreciation to USD. The latter took place despite high oil prices, as Russia’s strong current account surplus of US$100bn pa is neutralised by private capital outflow and budget-rule-related FX interventions. RUB is now driven by EM portfolio flows more than by anything else.

The RUB depreciation is only one of several contributors to the deterioration in the CPI trend. Other factors include higher local gasoline prices, stemming from high oil prices, hikes in local excise tax, overall tax manoeuvres in the oil industry, and the upcoming VAT rate hike from 18% to 20%. The VAT rate hike will take place in 2019 but may be triggering a front-loaded adjustment. As a result, the CPI, after bottoming out at 2.3% YoY mid-year, has now started to accelerate from its low base, and the forward looking inflationary expectations of households are on the rise. The CBR reversed the easing cycle in September by raising the key rate to 7.5%, accompanied by a worsening of its CPI outlook to 3.8-4.2% YoY for YE18, 5.5-6.0% YoY for 1H19 and 5.0-5.5% for YE19. The 2019 ranges could be considered threshold parameters for further hikes. To date the CPI trend has remained within the guidelines.

Despite the deteriorating GDP growth trend, the government has drafted a very tight budget for the next three years, assuming a 1-2% GDP surplus with the VAT tax hike, higher dividend collection from state companies and a reduction of expenditures to 17% of GDP, a 10-year low, and breakeven Urals has fallen to US$50/bbl. Unless the government is successful in reigniting a full-scale investment growth (which would be a positive surprise to our outlook), this tight budget policy framework may prove unsustainable if a decline in popular support for the political leadership follows. This could lead to pressure to ease the budget rule (leading to a halt in accumulation or even net spending of the National Welfare Fund depending on the scale). The effect of any easing on growth is likely to be modest and unlikely to be seen before 2020.

Source: Rosstat, ING

Key rate, CPI, and households’ inflationary expectations

Source: Bank of Russia, ING

Federal budget expenditures and popular support

Source: Levada Centre, Finance Ministry

-10%-8%-6%-4%-2%0%2%4%6%8%

Consumption Investments Net exportsInventories GDP, % YoY

7.50%9.3%

2%4%6%8%

10%12%14%16%18%

CPI, % YoY Key rate, % Expected CPI in 12М (HH)

3.5%

18%

18%

25%

22%

20%

19%

19%

19%

19%

19%

18%

17%

60%

70%

80%

90%

15%

17%

19%

21%

23%

25%

Federal budget expenditures, % GDP President's approval rating (rhs)

% GDP approvalrating



42

Moscow, +7 495 771 7994 [email protected]

Key indicators of consumer income and spending Households getting richer but less confident

Retail trade growth has stabilised at around 3% YoY despite the continued decline in unemployment to a new post-Soviet low of 4.5% and election-driven acceleration of real salaries (that account for two-thirds of household incomes) to 5-10% YoY. We believe households’ expectations (mostly low income) are under pressure of an expected deceleration in salary increase, the upcoming increase in VAT, and an increase in the retirement age. Meanwhile, retail loan growth, which is an indirect gauge of confidence in the higher-income segments, continues to accelerate to 20%+ YoY. Around 10ppt of this growth is attributable to unsecured consumer lending, which leads to the gradual tightening in the regulation. We see private consumption decelerating from 3.5% in 2018F to 1.5% in 2019F.

Source: Rosstat, ING

Companies’ capex and debt growth Investment demand limited

With large infrastructure projects related to the 2018 football World Cup and Crimea completed, investment growth is slowing. After 4.4% YoY in 2017, 1H18 growth slowed to 3.2% YoY. While the government is attempting to stimulate capex via by budgeting RUB3.5tr in state infrastructure investments for 2019-21F (1.1% of GDP pa) and attempting to compel higher private capex through dividend and tax policies, the viability of these efforts has yet to be seen. For now, the non-financial companies’ demand for debt capital, which is an indicator of investment activity, remains low. Currently, nominal leverage is growing by RUB1.3-1.5tr pa vs RUB3-6tr pa in 2011-13, as companies routinely reduce foreign debt, substituting it with local borrowing on the bond market and from banks.

Source: Bank of Russia, Rosstat, ING

Banks’ and companies’ foreign debt redemption Private demand for foreign capital low

Given the absence of strong investment activity and presence of external uncertainties, Russian corporates are reducing their foreign liabilities. In 3Q18, the net redemption totalled US$15bn (adjusted for FX revaluation), bringing the 9M18 figure to US$25bn and the post-sanction total (since mid-2014) to nearly US$170bn. Since 2017, the preference for refinancing of existing debt has declined to 71%, reflecting more active redemption. On the positive side, this deleveraging makes Russia less vulnerable to external risks, related to global capital outflows from EM to DM markets, and Russia-specific risks. On the negative side, however, this trend contributes to faster net capital outflow, effectively neutralising Russia’s strong current account and fuelling further expectations of RUB depreciation.

Source: Bank of Russia, ING

Local state debt (Finance Ministry’s plan) Public debt grows from low base, subject to volatility

The only source of demand for foreign capital (until 2018) has been the state, as foreign capital accounted for two-thirds of the growth in the rouble state bond (OFZ) market in 2015-17. This process was supported by Russia’s macro stability combined with expectations of RUB recovery and monetary policy easing amid favourable global sentiment towards EM risk. This trend broke in 2018, casting a shadow on Minfin’s significant RUB1.6-1.8 pa net OFZ placement programme for 2019-21F. We believe local banks, holding RUB3tr of liquidity, could partially offset the outgoing non-residents. Also, the programme could be reduced if USD/RUB is weaker than the drafted 64 (by RUB1.2-1.3tr for every RUB10/USD) or if the budget rule is eased (by RUB1.5-1.8tr for every US$10/bbl increase in cut-off Urals price).

Source: Finance Ministry, Bank of Russia, ING

4.0%4.5%5.0%5.5%6.0%6.5%7.0%7.5%8.0%

-20%-15%-10%

-5%0%5%

10%15%

Unemployment, % (rhs) Real salary, % YoY (lhs)Retail trade, % YoY (lhs)

5.7

3.25.1

2.71.0 1.5 1.3

9.1%5.0%

1.3%

-1.8%

-11.2%

0.8%4.4%

-12%-8%-4%0%4%8%12%16%20%24%

-3-2-10123456

Companies' debt 12M growth (lhs) Real CAPEX, % YoY (rhs)

RUB tr

-44 -44 -27 -26 -25

48%

65%74% 72% 71%

40%50%60%70%80%90%100%

-150

-120

-90

-60

-30

0

2H14 2015 2016 2017 9M18Scheduled gross corp. foreign debt redemptions, $bln (lhs)Actual change in foreign corp. debt, $bln (lhs)Share of refinanced foreign debt, % (rhs)

-125

-84-104 -95 -87

298642

1,107806

1,705 1,8001,578

194446

713

-377*9%9% 9%

10%

11%

12%13%

8%

9%

10%

11%

12%

13%

14%

-500

0

500

1,000

1,500

2,000

2015 2016 2017 2018F 2019F 2020F 2021FOFZ market growth, RUB bln Foreign inflows in OFZState local debt, % GDP

RUB bln

* - 9М18 % GDP



43

Russia Strategy


We have materially upgraded our USD/RUB expectations to RUB63 for YE18 mainly based on fundamentals. RUB should benefit from the strong current account, which was reported at US$26bn for 3Q18 and is set to widen to US$35bn in 4Q18F. This surplus will not be sterilised by CBR/MinFin FX interventions – those were suspended until end-2018. However, longer term, we again see RUB depreciation against the US$ to RUB65 by end-2019 as the CBR may resume FX interventions in 2019 and might even catch up on the US$30bn under-collected in 2018.

Our forecasts may seem too optimistic relative to current market expectations, and we see two major downside risks to our view.

The first, and most obvious is risk, is the expansion of sanctions, namely the possible ban on non-resident participation in new sovereign debt. Non-residents hold US$28-30bn in local OFZ and, if there were be sanctions, 30-100% of that sum could be withdrawn. We estimate that every US$5bn outflow weakens the RUB fair value (ie, the level likely to be reached after the initial shock settles) by RUB1/USD. That gives up to RUB6/USD downside risk related to sanctions.

The second risk is related to the general EM space. As Russia’s current account is routinely sterilised by ether FX interventions or private capital outflows, RUB has been trading in line with portfolio flow-driven peers. Currently, our global team expect the RUB peer basket to appreciate by 2% by YE18 and 8% by YE19 – supporting our generally favourable RUB outlook. Yet the global view is subject to risks related to US-China tensions and Fed tightening.


USD/RUB performance vs its peer* group

*EW FX basket of ZAR, BRL, TRL, MXN, MYR, NOK, COP Source: Bloomberg, ING

Local curve (%)


Russia money market indicators

Source: Bank of Russia, Bloomberg, ING

27

37

47

57

67

77

87

ING f'cast Mkt fwd

-40%

-30%

-20%

-10%

0%

405060708090

100

RUB discount to peers* (rhs) USD/RUB index (lhs)USD/peers* (lhs) INGF RUB peers* (lhs)INGF RUB (lhs)

RUB discount to peer basket (rhs)

7.0

7.5

8.0

8.5

9.0


468

1012141618

Mosprime 3M, % CBR key rate, %CBR fixed REPO rate, % CBR fixed DEPO rate, %

%


44

Russia 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018F 2019F 2020F

Activity Real GDP (% YoY) 5.2 -7.8 4.5 4.3 3.7 1.8 0.7 -2.5 -0.2 1.5 1.6 1.0 1.5 Private consumption (% YoY) 10.6 -5.1 5.5 6.8 7.9 5.2 2.0 -9.4 -2.8 3.4 2.5 1.0 1.5 Government consumption (% YoY) 3.4 -0.6 -1.5 1.4 2.6 0.9 -2.1 -3.1 0.9 0.4 0.5 1.0 1.0 Investment (% YoY) 10.6 -14.4 5.9 9.1 5.0 1.3 -1.8 -11.2 0.8 4.3 3.0 1.5 3.0 Industrial production (% YoY) 0.6 -10.7 7.3 5.0 3.4 0.4 1.7 -0.8 1.3 1.0 3.0 1.5 2.5 Unemployment rate (year-end, %) 7.7 8.0 7.0 6.0 5.1 5.6 5.3 5.8 5.4 5.2 4.5 4.7 4.7 Nominal GDP (RUBbn) 41,277 38,807 46,309 60,283 68,164 73,134 79,200 83,387 86,149 92,037 99,012 105,302 110,729 Nominal GDP (€bn) 678 639 847 1,034 1,310 1,213 826 956 1,320 1,378 1,372 1,347 1,299 Nominal GDP (US$bn) 996 894 1,134 1,447 1,690 1,613 1,090 1,052 1,392 1,571 1,592 1,630 1,663 GDP per capita (US$) 6,965 6,263 7,950 10,133 11,834 11,277 7,610 7,331 9,675 10,692 10,850 11,119 11,357 Gross domestic saving (% of GDP) 30.2 21.1 26.4 29.3 27.8 24.6 25.0 26.9 26.0 26.6 27.6 28.6 29.6


Fiscal balance (% of GDP) Consolidated government balance 4.9 -6.3 -3.4 1.4 0.4 -1.2 -1.1 -3.4 -3.7 -1.5 2.5 1.3 1.3 Consolidated primary balance 5.3 -5.6 -2.9 2.8 1.0 -0.5 -0.4 -3.0 -3.2 -0.6 3.6 2.5 2.6 Total public debt 6.5 8.3 9.0 9.4 9.8 10.6 11.8 12.5 13.3 12.6 12.9 13.7 14.7

External balance Exports (US$bn) 466 297 393 515 527 522 497 341 282 354 440 410 420 Imports (US$bn) 289 184 246 319 336 341 308 193 192 238 250 250 260 Trade balance (US$bn) 178 113 147 197 192 181 189 148 90 115 190 160 160 Trade balance (% of GDP) 17.8 12.7 13.0 13.6 11.3 11.2 17.3 14.1 6.5 7.3 11.9 9.8 9.6 Current account balance (US$bn) 104 50 67 97 71 33 58 69 26 33 110 80 90 Current account balance (% of GDP) 10.4 5.6 5.9 6.7 4.2 2.1 5.3 6.5 1.8 2.1 6.9 4.9 5.4 Net FDI (US$bn) 19.1 -6.7 -9.5 -11.8 1.8 -17.3 -35.1 -15.2 10.2 -8.2 -25.0 -10.0 0.0 Net FDI (% of GDP) 1.9 -0.7 -0.8 -0.8 0.1 -1.1 -3.2 -1.4 0.7 -0.5 -1.6 -0.6 0.0 Current account balance plus FDI (% of GDP) 12.4 4.9 5.1 5.9 4.3 1.0 2.1 5.1 2.6 1.6 5.3 4.3 5.4 Foreign exchange reserves ex gold (US$bn) 413 417 443 454 487 470 339 320 318 356 383 467 532 Import cover (months of merchandise imports) 17 27 22 17 17 17 13 20 20 18 18 22 25

Debt indicators Gross external debt (US$bn) 480 466 489 539 636 729 600 519 512 518 459 436 418 Gross external debt (% of GDP) 48.2 52.1 43.1 37.2 37.7 45.2 55.0 49.3 36.8 33.0 28.8 26.8 25.1 Gross external debt (% of exports) 103 157 124 105 121 140 121 152 182 147 104 106 100 Lending to corporates/households (% of GDP) 40.0 41.5 39.2 38.6 40.7 46.0 53.2 54.7 50.7 50.0 52.5 53.7 55.5

Interest & exchange rates Central bank key rate (year-end, %) n/a 6.00 5.00 5.25 5.50 7.50 17.00 11.00 10.00 7.75 7.50 7.50 6.50 Broad money supply (average, % YoY) 0.8 17.7 31.1 21.0 12.2 14.7 1.5 11.3 9.2 10.5 12.0 7.0 10.0 3m interest rate (Mosprime, average, %) 11.1 11.5 4.1 5.5 7.2 6.9 10.5 13.8 11.2 9.4 7.7 7.9 6.8 3m interest rate spread over US$-Libor(ppt) 655 1036 325 409 662 668 1030 1382 1142 968 802 815 678 2yr yield (average, %) 7.5 9.3 5.9 6.7 6.9 6.2 9.0 11.6 9.2 7.7 7.1 7.6 6.6 10yr yield (average, %) 7.6 11.2 7.6 8.6 8.2 7.5 9.5 11.1 8.9 7.9 7.9 8.1 7.1 USD/RUB exchange rate (year-end) 29.4 30.2 30.5 32.1 30.6 32.9 58.3 72.9 61.2 57.6 63.0 65.0 67.0 USD/RUB exchange rate (average) 41.4 43.4 40.8 41.7 40.3 45.3 72.7 79.3 61.9 58.6 62.2 64.6 66.6 EUR/RUB exchange rate (year-end) 41.1 43.2 40.9 41.8 40.3 45.1 70.5 79.5 64.6 69.1 72.5 81.3 87.1 EUR/RUB exchange rate (average) 60.9 60.7 54.7 58.3 52.0 60.3 95.9 87.2 65.3 66.8 72.2 78.2 85.2 Brent oil price (annual average, US$/bbl) 59 94 36 78 96 111 113 108 45 55 75 66 69



Real GDP (% YoY) 2.2 0.9 1.3 1.9 1.3 1.7 1.1 0.8 1.2 1.1 1.8 2.0 1.0 CPI (eop, % YoY) 3.0 2.5 2.4 2.3 3.4 4.0 5.2 5.7 5.4 4.8 3.6 3.2 3.4 Central bank key rate (eop, %) 8.50 7.75 7.25 7.25 7.50 7.50 7.50 7.50 7.50 7.50 7.25 6.75 6.50 3m interest rate (eop, %) 8.7 7.9 7.3 7.5 8.1 8.3 8.1 7.9 7.7 7.5 7.3 6.8 6.5 10yr yield (eop, %) 7.6 7.5 7.1 7.7 8.5 8.5 8.3 8.1 7.9 7.5 7.3 7.1 6.9 USD/RUB exchange rate (eop) 57.6 57.6 56.9 57.5 65.6 63.0 64.0 65.0 66.0 65.0 66.0 67.0 68.0 EUR/RUB exchange rate (eop) 69.1 69.1 68.3 67.3 75.4 72.5 73.6 76.7 79.2 81.3 83.2 85.1 87.0



45

Serbia Valentin Tataru, Economist, Romania

Forecast summary Country strategy: IMF poster child keeps on delivering 2Q18 3Q18F 4Q18F 1Q19F 2Q19F 2018F 2019F

Real GDP (% YoY)* 4.8 3.7 4.5 3.9 3.5 4.5 3.7 CPI (% YoY)* 2.3 2.1 2.8 3.0 3.0 2.3 2.8 Central bank key rate (%)* 3.00 3.00 3.00 3.00 3.00 3.00 3.25 3m interest rate (%)* 2.88 2.92 3.00 3.00 3.00 2.93 3.06 10yr yield (%)* 4.70 4.60 4.60 4.60 4.60 4.75 4.65 USD/RSD* 100.8 102.9 103.0 102.6 99.6 101.27 98.43 EUR/RSD* 117.9 118.3 118.5 118.0 117.5 118.20 117.50


Activity Presidential: Apr 2022 S&P BB BB Fiscal Neutral Parliamentary: Apr 2020 Moody’s Ba3 Ba3 Monetary Loose Local: Mar 2022 Fitch BB BB

The Serbian economy is enjoying the benefits of past reforms and prospects of EU membership, with investment boosting growth, capital inflows supporting the RSD and core inflation tamed, allowing the central bank to lower borrowing costs. The 30 month precautionary deal with the IMF agreed in June 2018 seems effective, with the IMF last citing “dramatic improvements in the last few years”. This will allow the government to abolish the pension cuts from 2014 while also relaxing labour taxation. A bold increase in capital spending is also planned for next year for which a -0.5% of GDP budget deficit has already been agreed with the IMF, following two consecutive years of fiscal surpluses.


Real GDP (% YoY) and contributions (ppt) Solid growth prospects

The first two quarters of 2018 saw impressive 4.9% and 4.8% YoY GDP growth on the back of a booming construction sector (+23% in 2Q18) and an above-expectations contribution from agriculture. On the expenditure side, investments and private consumption continue to perform very well with the already announced pensions and public wage increases set to further boost consumption. Consider this together with the government’s plan to spend over RSD200bn (€1.7bn) on capital investments in 2019 and our 3.7% GDP growth forecast for next year starts to look conservative. The labour market offers caution, with workforce resources quickly employed.

Source: Thomson Reuters, ING

Fiscal and primary balance as % of GDP On the right track

2017 marked the first year since 2005 for Serbia to record general fiscal and primary surpluses. The positive trend continued in 2018, allowing for a swift reduction in public debt levels with the debt-to-GDP ratio set to close the year below 60%. The fiscal impulse planned for 2019 should be a mix of higher pensions and wages, lower taxes and increased public investments. A mildly loose NBS monetary policy on rising CPI, should keep borrowing costs at record low levels, improving the transmission mechanism and further boost the dinarisation of the economy. While declining, the share of hard currency public debt remains quite high, at c.75%. This will still require active management of the exchange rate by the NBS.

Source: Ministry of Finance, ING

-6-4-202468

-6-4-202468

2Q13 4Q13 2Q14 4Q14 2Q15 4Q15 2Q16 4Q16 2Q17 4Q17 2Q18Private consumption Public consumptionInvestments Net exportsOthers GDP (%YoY,rhs)

-0.5

2.7

-7-6-5-4-3-2-101234

2011 2012 2013 2014 2015 2016 2017 2018 2019

Budget balance Primary balance

ING forecast



46

Serbia 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018F 2019F 2020F

Activity Real GDP (% YoY) 5.4 -3.1 0.6 1.4 -1.0 2.6 -1.8 0.7 2.8 1.9 4.5 3.7 3.6 Private consumption (% YoY) 6.1 -0.2 -0.6 1.0 -2.0 -0.6 -1.3 0.5 1.0 1.8 3.1 2.9 2.8 Government consumption (% YoY) 3.9 -1.7 0.1 0.9 2.0 -1.1 -0.6 -1.7 2.3 1.1 2.0 2.0 1.5 Investment (% YoY) 8.2 -22.6 -6.5 4.6 13.2 -12.0 -3.6 5.7 5.0 5.8 6.8 6.4 7.0 Industrial production (% YoY) 1.1 -12.6 1.2 2.5 -2.6 6.1 -7.4 7.3 4.9 4.2 4.5 6.3 6.0 Unemployment rate (year-end, %) 14.7 17.4 20.0 24.4 23.1 22.1 19.2 17.7 16.1 14.3 12.1 10.0 7.4 Nominal GDP (RSDbn) 2,745 2,880 3,067 3,408 3,584 3,876 3,908 4,043 4,262 4,465 4,780 5,100 5,450 Nominal GDP (€bn) 31 30 29 33 32 34 32 33 35 37 40 43 47 Nominal GDP (US$bn) 49 43 39 47 41 46 44 37 38 42 47 52 60 GDP per capita (US$) 6,700 5,800 5,400 6,400 5,700 6,400 6,200 5,200 5,400 6,000 6,700 7,500 8,700 Gross domestic saving (% of GDP) 5.3 3.5 3.5 4.7 4.3 6.9 6.7 9.1 11.6 12.2 12.0 11.9 11.8

Prices CPI (average, % YoY) 12.4 8.1 6.1 11.1 7.3 7.7 2.1 1.4 1.1 3.1 2.3 2.8 3.0 CPI (year-end, % YoY) 8.6 6.6 10.2 7.0 12.2 2.2 1.8 1.6 1.5 3.0 2.8 2.7 3.4 Wage rates (nominal, % YoY) 18.1 -2.9 7.5 11.2 9.0 6.2 1.4 -0.2 3.7 1.5 5.0 5.3 5.7

Fiscal balance (% of GDP) Consolidated government balance -2.6 -4.4 -4.6 -4.8 -6.8 -5.5 -6.6 3.7 -1.3 1.2 0.2 -0.5 -0.5 Consolidated primary balance -2.0 -3.6 -3.5 -3.5 -4.9 -3.1 -3.7 -0.4 1.8 3.9 2.9 2.7 2.4 Total public debt 26.1 32.1 40.8 47.0 58.0 61.1 71.8 75.1 72.5 61.6 57.3 54.2 51.2

External balance Exports (€bn) 7.5 6.0 7.4 8.5 8.8 11.1 11.1 12.0 13.4 14.7 16.1 18.0 20.1 Imports (€bn) 15.6 11.5 12.6 14.3 14.7 15.5 15.4 16.4 17.4 19.8 21.7 23.9 26.3 Trade balance (€bn) (8.1) (5.5) (5.2) (5.8) (5.9) (4.4) (4.3) (4.3) (4.0) (5.1) (5.6) (5.9) (6.2) Trade balance (% of GDP) -24.1 -18.1 -17.7 -17.4 -18.6 -12.8 -12.8 -13.0 -11.6 -13.9 -13.9 -13.6 -13.2 Current account balance (€bn) (7.1) (2.0) (2.0) (3.7) (4.7) (2.8) (2.6) (1.8) (1.2) (2.3) (2.7) (2.9) (2.8) Current account balance (% of GDP) -21.2 -6.5 -6.7 -11.1 -14.9 -8.1 -7.9 -5.2 -3.4 -6.4 -6.7 -6.7 -6.0 Net FDI (€bn) 1.8 1.4 1.3 3.5 0.9 1.8 1.7 2.0 2.1 2.7 2.8 2.9 3.0 Net FDI (% of GDP) 5.4 4.6 4.3 10.6 2.8 5.1 5.0 6.0 5.0 7.4 7.0 6.8 6.5 Current account balance plus FDI (% of GDP) -15.8 -2.0 -2.5 -0.5 -12.2 -3.0 -2.9 0.7 1.6 1.0 0.3 0.1 0.5 Foreign exchange reserves ex gold (€bn) 8.8 11.7 11.2 12.3 11.4 11.6 11.1 11.2 11.1 10.4 12.5 12.8 14.0 Import cover (months of merchandise imports) 6.8 12.2 10.7 10.4 9.3 9.0 8.6 8.2 7.6 6.3 6.9 6.4 6.4


Interest & exchange rates Central bank key rate (year-end, %) 17.75 9.50 11.50 9.75 11.25 9.50 8.00 4.50 4.00 3.50 3.00 3.25 3.50 Broad money supply (average, % YoY) 29.6 11.5 19.7 6.6 14.7 5.6 5.9 5.8 9.2 8.0 5.9 7.8 9.3 3m interest rate (Belibor, average, %) 15.6 14.4 10.8 12.9 11.7 10.1 8.3 6.1 3.4 3.4 3.0 3.3 3.5 3m interest rate spread over Euribor (ppt) 11.0 13.2 9.9 11.5 11.1 9.9 8.0 6.1 3.7 3.7 3.3 3.5 3.5 2yr yield (average, %) n/a n/a n/a 13.2 13.5 10.8 9.2 7.3 4.7 4.2 3.4 3.5 3.9 10yr yield (average, %) n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a 4.8 4.6 4.8 USD/RSD exchange rate (year-end) 62.9 66.7 79.3 80.9 86.2 83.1 99.5 111.2 117.1 99.3 103.0 93.6 88.5 USD/RSD exchange rate (average) 55.8 67.6 78.6 73.1 88.0 84.9 89.1 109.4 111.8 105.5 102.4 97.3 90.6 EUR/RSD exchange rate (year-end) 88.6 95.9 105.5 104.6 113.7 114.6 121.0 121.6 123.5 119.1 118.5 117.0 115.0 EUR/RSD exchange rate (average) 81.9 94.1 103.5 102.0 113.6 113.1 117.4 120.8 123.2 121.3 118.8 117.8 116.0



Real GDP (% YoY) 2.3 2.4 4.9 4.8 3.7 4.5 3.9 3.5 3.9 3.7 3.6 3.9 3.3 CPI (eop, % YoY) 3.3 3.0 1.4 2.3 2.1 2.8 3.0 3.0 2.7 2.7 2.6 2.9 3.3 Central bank key rate (eop, %) 3.75 3.50 3.25 3.00 3.00 3.00 3.00 3.00 3.00 3.25 3.50 3.50 3.50 3m interest rate (eop, %) 3.30 3.12 2.91 2.88 2.92 3.00 3.00 3.00 3.00 3.25 3.40 3.45 3.50 10yr yield (eop, %) n/a n/a 5.1 4.7 4.6 4.6 4.6 4.6 4.7 4.8 4.80 4.90 4.90 USD/RSD exchange rate (eop) 99.3 99.3 98.4 100.8 102.9 103.0 102.6 99.6 97.9 93.6 92.5 91.3 90.2 EUR/RSD exchange rate (eop) 119.2 119.1 118.1 117.9 118.3 118.5 118.0 117.5 117.5 117.0 116.5 116.0 115.5



47

Turkey Muhammet Mercan, Chief Economist


Real GDP (% YoY) 5.2 3.3 -1.4 -3.5 -1.1 3.3 0.3 CPI (% YoY)* 15.4 24.5 25.7 25.6 21.9 17.2 20.9 Policy interest rate (eop, %) 17.75 24.00 24.00 26.00 24.00 24.00 21.00 3m interest rate (%)* 18.83 27.31 27.70 27.93 24.63 20.22 24.52 10yr yield (%)* 16.77 17.92 19.80 19.95 17.47 16.36 17.37 USD/TRY* 4.59 6.06 5.80 6.03 6.26 4.94 6.31 EUR/TRY* 5.37 6.96 6.67 6.93 7.39 5.68 7.88


Activity Presidential: Jun-23 S&P B+ BB- Fiscal Tighter Parliamentary: Jun-23 Moody’s Ba3 Ba3 Monetary Tighter Local: Mar-19 Fitch BB BB+

A less supportive global backdrop together with USD strength, geopolitical issues (deteriorating Turkey-US relations) and macro imbalances have been factors that have shifted the focus to Turkey, with significant volatility in domestic financial markets in 2018. Following the August developments, concerns about the economy’s large FX debt service have risen as overall external financing needs have increased. Given this backdrop and after the September rate adjustment by the CBT, implementation of the government’s action plan and likely steps for the banking sector are key for stabilization of domestic financial markets. The MTP provides a prudent fiscal stance, which will support the already sharply tightened monetary policy to rebalance the economy to a more sustainable path.


GDP Growth (% YoY) Macro digest

The Turkish economy grew very fast last year, with strongly expansionary macroeconomic policies in place since the failed coup attempt in mid-2016. This year, solid growth continued in 1Q18, at 7.3% YoY, while economic activity was broadly in line with expectations in 2Q18 at 5.2% YoY. 1H18 performance is attributable to government fiscal measures to support private consumption and to investment, with increasing capital spending ahead of early general elections last June. Still, domestic demand lost momentum in 2Q, while the contribution of net exports turned positive. With increased financial volatility weighing on sentiment, difficulties in external financing and the spike in inflation, growth will slow at a faster rate. In addition, the CBT hiking cycle will have a significant impact on domestic demand while financial market volatility is likely to make consumers and investors cautious, despite an expected recovery in net exports (with strong tourism and increasing price competitiveness). Fiscal tightening as signalled by the MTP will not help the growth outlook. Recent data – with PMI below the 50 threshold since March 2018, a marked decline in sectoral confidence indicators, softening IP and retail sales and economic confidence at its lowest since the global crisis when Turkey was in recession - reinforces the downbeat economic outlook from 2H onwards. Given this, we expect 3.3% GDP growth this year and 0.3% in 2019, but cannot rule out a contraction. In the MTP, the government foresees a soft landing with 2.3% growth next year, quite optimistic compared with consensus that likely reflects a lower rate path, and with a less challenging global backdrop than expected.

Following a big surprise in September, the highest monthly inflation since the 2001 financial crisis, consumer prices increased further in October despite the 10% price cut campaign. Annual inflation went up further to 25.24% from 24.52% a month ago, contributed by: (1) continuing deterioration in goods inflation, especially energy and processed foods, given the ongoing impact of exchange rate pass through and also administrative adjustments, despite unprocessed foods recorded price increases less than seasonality would suggest, and (2) continuing rise in sticky services inflation, though transportation services show price declines. The data shows the inflation outlook remains poor with ongoing pressure in the price dynamics driven by cost factors, while inflation is likely to have more room to run given that domestic PPI stands at around 45%. Evolution of the exchange rate and food prices is likely to determine the CPI trend given the ongoing slowdown in demand pressures, while the current uptrend will continue a few months more and likely peak in early 2019 with upside risks prevailing in the short-term. We now expect close to 26% inflation this year and 15.3% next year.

Source: TurkStat, ING Bank

PMI & CUR (seas. adj., 3m-ma, % YoY)

Source: Markit, TurkStat, ING Bank

Inflation (% YoY)

Source: TurkStat, ING Bank

-5

0

5

10

15

Domestic demand Net foreign demand GDP growth

74.5

75.5

76.5

77.5

78.5

79.5

45

47

49

51

53

55

57

PMI CUR (rhs)

25.229.6

14.8

24.3

5

10

15

20

25

30

10/16 01/17 04/17 07/17 10/17 01/18 04/18 07/18 10/18

CPI Goods Services Core Inflation (C)



48

Istanbul, +90 212 329 0751 [email protected]

Unemployment vs NPLs (%) Unemployment on an uptrend

The seasonally adjusted unemployment rate has gone up from 9.9% end-2017 to 11.0% in July. This suggests an uptrend has already started and will likely remain, with ongoing weakening in the growth outlook. In the medium term plan, the government acknowledges the need for a soft landing with a modest growth rate forecast in 2019 while it also accepts tightening in the labour market conditions and increase in the unemployment rate with forecasts of 11.3% (average) this year and 12.1% (average) next. The recent volatility is anticipated to lead to asset quality deterioration. In the global financial crisis, the NPL ratio in the sector peaked at 5.4% and declined rapidly later. It currently stands at 3.2%. Higher NPLs would require higher loan-loss provisions, negatively affecting sector profitability.

Source: TurkStat, BRSA, ING Bank

Breakdown of C/A financing (12m-rolling, US$bn) External deficit rapidly narrowing

With weaker domestic demand on increased financial volatility, an uptrend in inflation, sharp monetary tightening since early 2018 and improved price competitiveness supporting exports, external balances have started to improve quickly. This is evidenced by the first C/A surplus since September 2015 in August, also the largest monthly C/A surplus on record. External financing – reflecting the impact of a less supportive global backdrop, rising geopolitical risks, volatility in global financial markets and higher risk perception for Turkey – is becoming increasingly challenging. Accordingly, we saw acceleration in resident outflows and significant weakening in portfolio flows leading to large reserve depletion despite strong unexplained inflows in recent months.

Source: CBT, ING Bank

Primary balance (12m-rolling, % of GDP) Ambitious fiscal targets

With fiscal easing since mid-2016 - also evident in this year’s budget metrics - along with increasing reliance on quasi-fiscal spending channels, the medium term programme (MTP) is a key policy action from the government. It expects the central administration budget balance-to-GDP ratio to remain under control and the size of the primary surplus-to-GDP ratio to gradually improve and to return to pre-2016 levels in 2021. The MTP programme is a step in the right direction - with modest growth, reasonable inflation, and ambitious fiscal targets. Lately the government unveiled a tax cut package aimed at economic recovery. This should not have any meaningful impact on the 2019 fiscal plans, nor be a major source of inflationary pressure either, given their temporary nature.

Source: Ministry of Treasury and Finance, ING Bank

Banking sector external debt* (US$bn) Operating outlook challenging for the banking sector

Recent financial volatility is likely to affect the banking sector in the form of: (1) weakening asset quality; (2) the FX effect on CAR - banks have more on-balance-sheet FX liabilities than FX assets although the net FX position is small once off-BS exposures are considered - with equity predominately denominated in TRY, a weaker TRY puts pressure on CAR as it leads to inflation in RWAs with no significant corresponding change to equity; (3) declines in asset prices due to market turbulence; (4) interest rate sensitivity given that liabilities, namely deposits, re-price faster; and (5) general uncertainty, with a negative effect on revenues through less customer activity. The Banking Regulation and Supervision Agency has introduced forbearance measures to limit the impact on banks’ capital position.

* Incl. state banks (excl. non-bank FIs) Source: Treasury, CBT, BRSA, ING Bank

2.7

2.9

3.1

3.3

3.5

9

10

11

12

Unemployment Rate (sa, lhs) NPLs

11-2 1 -9 -26 -11 -10 -21

1613 13 13 18 13 11 11

1938 21 21

-10

8 24

4

1719 37 18

2813

14

17

2

-21 -10

0

12

-1

8

20

9

13 2

1011

1

20

-40%

-20%

0%

20%

40%

60%

80%

100%

2011 2012 2013 2014 2015 2016 2017 08/18

Resident flows FDI Portfolio flows

Borrowing & other Reserves (- = incr.) Net E&Os

-2

-1

0

1

2

9/09 6/10 3/11 12/11 9/12 6/13 3/14 12/14 9/15 6/16 3/17 12/17 9/18

Primary balance (program definition) / GDPPrimary balance / GDP

50

54

58

62

66

70

50

80

110

140

170

200

3Q11 2Q12 1Q13 4Q13 3Q14 2Q15 1Q16 4Q16 3Q17 2Q18

Short term (residual basis) Treasury external debtShare (%, rhs)



49

Turkey Strategy


The TRY has outperformed peers since early September, thanks to the CBT's reaction in the form of a sharp rate hike, making the currency the highest yielding in the EM space in nominal terms. The new economic programme is a step in the right direction, as it acknowledges the need for a soft landing and an improvement in external imbalances while anticipating a return to fiscal discipline. The TRY has further strengthened in recent weeks, in line with the EM bounce and better newsflow on political issues - including the release of US pastor Brunson, statements from the US that some sanctions could be lifted after the release and finally a more conciliatory US tone on reducing Turkey’s imports of Iranian oil before the resumption of US sanctions in November. All this points to improvements in the geopolitical picture that will likely support the capital flow outlook. Finally, the ongoing improvement in external imbalances on the back of rapid weakening in domestic demand sharply weighing on imports may continue to support TRY rebound sentiment. With a strengthening TRY leading to: (1) a decline in FX pass-through on inflation, given the high correlation between TRY performance and core inflation; and (2) improving financial stability with an improving operating environment for Turkish corporates with large short FX positions - the CBT remains mute despite elevated inflation and a surge in forward-looking expectations and a fall in the ex-post real rate to negative territory again. With inflation to remain in double digits for some time, the possibility of political noise ahead of local elections and a challenging global backdrop, the TRY may see another bout of volatility ahead.

Source: Bloomberg, ING estimates

CBT policy rate & Interest rate corridor (%)

Source: CBT, ING Bank

Local curve (%) Fixed income strategy

While TRY rebound sentiment has prevailed lately, the appetite for local bonds is not as strong. The continuing hawkish bias of the CBT, with a determination to tighten further, if needed, continues to support the long end of the curve. Accordingly, 10Y bond yields that hit 23% in early August have come down to below 17% recently. Given the tight policy stance, the yield curve has remained heavily inverted with 2v10Y close to -500bp. With some degree of normalization in Turkish markets on the back of responses by policy makers over the past month that have been sufficient to stabilize markets, non-residents’ activity in local bonds has recovered to some extent in October. Benign inflation readings could help improve sentiment and contribute further foreign flows while risks are on the upside for headline CPI on the back of a broad-based pick-up in price pressures. There has been an across-the-board increase in all major price categories, continuation of the exchange rate impact, and strengthening cost-led price pressures as evidenced by annual PPI inflation widening to 45%. After a strong rally since mid-October, any downtrend in local yields is likely to be limited by: (1) potential weakening in risk appetite for EM assets in the period ahead so a replay of market stress cannot be ruled out; (2) additional policy tightening could also be on the table given elevated inflation levels, a real policy rate (ex-post) in negative territory again and a reactive monetary policy stance; and (3) heavy supply pressure in November, with TRY22.4bn according to the Treasury’s borrowing programme.

Source: Bloomberg, ING estimates

Real interest rate (%)

Source: Treasury, CBT, ING Bank

2.53.03.54.04.55.05.56.06.57.0

ING f'cast Mkt fwd

6085110135160185

710131619222528

Funding (TRY bn, rhs) BIST O/N Repo RateO/N Borrowing Rate 1W Repo RateO/N Lending Rate Cost of CBT FundingLate Liquidity Window Rate

15

18

21

24

27

30


0

2

4

6

8

10

6

9

12

15

18

21

9/13 3/14 9/14 3/15 9/15 3/16 9/16 3/17 9/17 3/18 9/18

Treasury's borrowing 12M Inflation exp. Real rate (rhs)


50

Turkey 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018F 2019F 2020F

Activity Real GDP (% YoY) 0.8 -4.7 8.5 11.1 4.8 8.5 5.2 6.1 3.2 7.4 3.3 0.3 2.7 Private consumption (% YoY) 0.3 -3.7 10.8 12.3 3.2 7.9 3.0 5.4 3.7 6.1 4.5 1.2 3.6 Government consumption (% YoY) 3.5 8.1 1.7 1.1 6.8 8.0 3.1 3.9 9.5 5.0 -0.6 -7.9 0.1 Investment (% YoY) -2.7 -20.5 22.5 23.8 2.7 13.8 5.1 9.3 2.2 7.8 0.2 -2.4 3.0 Industrial production (% YoY) -0.9 -10.7 13.7 14.7 4.2 7.2 5.7 5.8 3.4 8.9 4.0 0.3 3.2 Unemployment rate (year-end, %) 10.0 13.0 11.1 9.1 8.4 9.0 9.9 10.3 10.9 10.9 10.7 12.2 11.8 Nominal GDP (TRYbn) 995 999 1,160 1,394 1,570 1,810 2,044 2,339 2,609 3,107 3,831 4,627 5,374 Nominal GDP (€bn) 551 450 575 639 666 683 770 784 820 711 675 587 597 Nominal GDP (US$bn) 770 645 770 828 878 939 932 851 861 853 776 734 776 GDP per capita (US$) 10,931 8,980 10,560 11,205 11,588 12,480 12,112 11,014 10,807 10,627 9,543 8,908 9,310 Gross domestic saving (% of GDP) 20.7 24.9 29.4 26.4 28.0 27.2 26.6 25.5 25.4 27.6 28.0 27.5


Fiscal balance (% of GDP) Consolidated government balance -1.8 -5.3 -3.5 -1.3 -1.9 -1.0 -1.1 -1.0 -1.1 -1.5 -2.0 -1.9 -1.8 Consolidated primary balance 3.3 0.0 0.7 1.8 1.2 1.7 1.3 1.3 0.8 0.3 -0.1 0.6 1.0 Total public debt 38.1 43.9 40.1 36.5 32.7 31.4 28.8 27.6 28.3 28.3 32.8 32.1 31.2

External balance Exports (US$bn) 139.7 108.9 120.0 142.0 161.6 161.8 168.9 152.0 150.2 166.2 178.6 199.7 221.0 Imports (US$bn) 192.7 133.8 176.4 231.1 227.0 241.7 232.5 200.1 191.1 225.1 224.7 235.7 265.1 Trade balance (US$bn) -53.0 -24.9 -56.4 -89.1 -65.3 -79.9 -63.6 -48.1 -40.9 -59.0 -46.0 -36.0 -44.1 Trade balance (% of GDP) -6.9 -3.9 -7.3 -10.8 -7.4 -8.5 -6.8 -5.7 -4.7 -6.9 -5.9 -4.9 -5.7 Current account balance (US$bn) -40.4 -12.2 -45.4 -75.1 -48.5 -65.0 -43.6 -32.1 -33.1 -47.5 -31.9 -18.6 -25.4 Current account balance (% of GDP) -5.3 -1.9 -5.9 -9.1 -5.5 -6.9 -4.7 -3.8 -3.8 -5.6 -4.1 -2.5 -3.3 Net FDI (US$bn) 17.0 6.9 7.6 13.7 9.2 9.2 5.5 12.5 10.2 8.3 7.7 8.6 9.5 Net FDI (% of GDP) 2.2 1.1 1.0 1.7 1.0 1.0 0.6 1.5 1.2 1.0 1.0 1.2 1.2 Current account balance plus FDI (% of GDP) -3.1 -0.8 -4.9 -7.4 -4.5 -5.9 -4.1 -2.3 -2.7 -4.6 -3.1 -1.4 -2.0 Foreign exchange reserves ex gold (US$bn) 70.1 69.6 80.7 78.3 100.3 112.0 106.3 95.7 92.1 84.1 75.7 77.5 84.5 Import cover (months of merchandise imports) 4.4 6.2 5.5 4.1 5.3 5.6 5.5 5.7 5.8 4.5 4.0 3.9 3.8


Interest & exchange rates Central bank key rate (year-end, %) 15.00 6.50 6.50 5.75 5.50 4.50 8.25 7.50 8.00 8.00 24.00 21.00 17.00 Broad money supply (average, % YoY) 26.7 13.0 19.1 14.8 10.2 22.2 11.9 17.1 18.3 15.7 24.3 21.8 17.1 3m interest rate (TRLibor, average, %) 17.6 10.2 7.4 8.8 8.9 6.9 10.1 10.9 10.1 12.7 20.2 24.5 18.7 3m interest rate spread over US$-Libor (ppt) 1287 877 718 847 836 659 989 1062 927 1135 1776 2138 1516 2yr yield (average, %) 19.3 11.4 8.4 9.1 8.1 7.6 9.2 9.8 9.7 11.8 19.9 20.6 14.8 10yr yield (average, %) n/a n/a 9.8 9.6 8.5 8.3 9.3 9.4 10.1 11.0 16.4 17.4 13.1 USD/TRY exchange rate (year-end) 1.51 1.51 1.55 1.91 1.78 2.13 2.32 2.92 3.53 3.79 5.80 6.70 7.11 USD/TRY exchange rate (average) 1.29 1.55 1.51 1.68 1.79 1.93 2.19 2.75 3.03 3.64 4.94 6.31 6.92 EUR/TRY exchange rate (year-end) 2.21 2.11 2.21 2.55 2.31 2.82 3.19 3.53 3.92 4.29 6.78 7.92 9.04 EUR/TRY exchange rate (average) 1.81 2.22 2.02 2.18 2.36 2.65 2.65 2.98 3.18 4.37 5.68 7.88 9.00 Brent oil price (annual average, US$/bbl) 97.3 61.8 79.9 112.1 112.4 109.6 99.4 52.1 43.3 54.8 73.3 65.8 69.0



Real GDP (% YoY) 7.3 7.3 5.2 3.3 -1.4 -3.5 -1.1 1.8 3.4 2.6 2.8 2.5 2.7 CPI (eop, % YoY) 11.9 10.2 15.4 24.5 25.7 25.6 21.9 15.9 15.3 15.4 14.7 12.7 10.6 Central bank key rate (eop, %) 8.00 8.00 17.75 24.00 24.00 26.00 24.00 21.00 21.00 20.00 19.00 18.00 17.00 3m interest rate (eop, %) 14.61 13.65 18.83 27.31 27.70 27.93 24.63 21.44 20.88 20.07 19.04 17.81 16.70 10yr yield (eop, %) 11.74 12.55 16.77 17.92 19.80 19.95 17.47 15.14 14.81 14.51 13.57 11.98 11.27 USD/TRY exchange rate (eop) 3.79 3.95 4.59 6.06 5.80 6.03 6.26 6.51 6.70 6.80 6.90 7.01 7.11 EUR/TRY exchange rate (eop) 4.55 4.75 5.37 6.96 6.67 6.93 7.39 7.81 8.38 8.57 8.77 8.97 9.25



51

Ukraine Dmitry Dolgin, Chief Economist, Russia & CIS


Real GDP (% YoY) 3.8 2.7 2.6 2.2 2.7 3.1 2.9 CPI (% YoY)* 9.9 8.9 9.5 8.3 8.1 10.9 8.1 Policy interest rate (eop, %) 17.00 18.00 18.00 18.00 18.00 18.00 16.00 3m interest rate (%)* n/a n/a n/a n/a n/a n/a n/a 10yr yield (%)* n/a n/a n/a n/a n/a n/a n/a USD/UAH * 26.34 28.24 30.00 29.50 30.00 27.79 29.90 EUR/UAH* 30.81 32.48 34.50 33.93 35.40 32.23 36.18


Activity Presidential: Mar-19 S&P B- B- Fiscal Tighter Parliamentary: Oct-19 Moody’s Caa2 WR Monetary Tighter Local: Fitch B- B-

2018 growth momentum is likely to continue next year, but slower, with domestic demand still growing on rises in minimum wages and pensions and remittances to Ukraine. Some downside risks stem from higher CPI dynamics, tighter monetary policy, and the tight fiscal policy required by the IMF. Recent agreement with the IMF seems to be positive for sentiment ahead of FX debt redemption and servicing (US$8.3bn) in 2019. Approval of the IMF-compliant budget for 2019 might be tense, with proposed tax changes and elections due in Mar/Oct-19. We assume the first tranche to be disbursed to Ukraine by end-2018/early-2019. Together with EU/World Bank funds, this should boost Ukraine’s FX reserves to US$20bn. Political uncertainty on 2019-elections remains.


GDP growth and major contributors (% YoY) Economic recovery set to continue next year

2Q18 GDP growth accelerated to 3.8% YoY vs 3.1% in 1Q18, mainly fuelled by solid domestic demand expansion (+7.4ppt) offsetting the negatives from net exports (-1.7ppt) and inventories (-1.6ppt). Public spending was up 11.0% YoY due to higher H/H utility subsidies. Private consumption contributed 4.2%, on robust real wage growth (+12.8% YoY in 8M18) and improved consumer sentiment. Investments grew 14.2% YoY, with bigger budget capex on infrastructure. We revised up our GDP growth print for 2018 to 3.1% expecting some moderation in 2019 with sufficiently tight monetary policy aimed at addressing heightened inflationary pressure and tighter fiscal policy, subject to IMF requirements.

Source: CEIC, ING

Current account/ fiscal balance (12M rolling, % of GDP) 2019 budget draft approval key for the IMF tranche

After weaker performance in April-July, the 12M-rolling consolidated gov’t budget saw a gap of 2.5% of GDP in Aug-18 (in line with the IMF target), with revenues/outlays up by 15%/23%YoY in 8M18. In the next couple of months the key focus will be on approval of the 2019 budget draft (required for the IMF tranche) that sets the gap at 2.3% of GDP. For now this seems a concern as it does not cover the recent gov’t decision to hike H/H gas prices by 23.5% since Nov-18 and the proposal to replace CIT with tax on distributed profits (if agreed, this might reduce receipts by UAH27-40bn). On the external side, the C/A gap widened further to US$2.1bn in 8M18 (vs US$0.8bn in 8M17) with the F/A surplus at US$2.2bn (vs US$2.1bn in 8M17).

Source: CEIC, ING

USD/UAH and NBU FX reserve dynamics New IMF deal looks supportive for UAH/sovereign debt

On 19 October, the IMF announced a new 14 month standby agreement for US$3.9bn aid to Ukraine as a substitute for the remaining US$8.6bn (out of US$17.5bn) under the EFF programme. With no budget deadlocks, we expect the first IMF-tranche by end-2018 or early-2019. That in turn will unlock EU/World Bank funds of US$1.8bn to replenish FX reserves that had declined to US$16.6bn (or 2.8 months of imports) in Sep-18. Following the IMF deal, Ukraine allocated US$1.25bn in 10yr/US$0.75bn in 5yr Eurobonds. All in all, that will secure the major FX debt repayments of US$8.3bn in 2019. In 1Q19 Ukraine joins Clearstream that, alongside government initiatives on investor protection, might boost local debt demand.

Source: NBU

-20%-15%-10%-5%0%5%10%15%

-35%

-25%

-15%

-5%

5%

15%

25%

Domestic demand Net exportsInventories GDP (rhs, %YoY)

-10.0%

-7.0%

-4.0%

-1.0%

2.0%

5.0%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0% Consolidated gov't budget balance (lhs)Current account balance (rhs)

0

5

10

15

20

25

5

10

15

20

25

30NBU FX reserves, US$bn (rhs) USD/UAH (lhs)



52

Ukraine 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018F 2019F 2020F

Activity Real GDP (% YoY) 2.3 -14.8 4.1 5.5 0.2 0.0 -6.6 -9.8 2.4 2.5 3.1 2.9 3.0 Private consumption (% YoY) 13.1 -14.9 7.0 15.7 8.4 6.9 -8.3 -20.7 2.1 7.8 4.6 4.0 3.0 Government consumption (% YoY) 1.1 -2.4 4.2 -2.9 4.5 -0.9 1.1 1.7 -0.5 3.3 2.3 1.5 1.0 Investment (% YoY) -1.2 -50.5 3.2 8.5 5.0 -8.4 -24.0 -9.2 20.4 18.2 10.0 7.0 6.7 Industrial production (% YoY) -5.0 -20.6 12.2 8.0 -0.7 -4.3 -10.1 -13.0 2.8 0.4 2.4 3.0 3.2 Unemployment rate (year-end, %) 6.4 8.8 8.2 8.0 7.6 7.3 9.3 9.1 9.3 9.5 9.4 9.3 9.2 Nominal GDP (UAHbn) 948 913 1,079 1,300 1,405 1,465 1,587 1,989 2,385 2,983 3,408 3,790 4,203 Nominal GDP (€bn) 123 81 101 116 135 135 100 82 85 98 106 105 108 Nominal GDP (US$bn) 180 113 136 163 174 180 132 91 93 112 123 127 138 GDP per capita (US$) 3,906 2,465 2,965 3,568 3,815 3,958 3,075 2,121 2,192 2,647 2,897 2,996 3,260 Gross domestic saving (% of GDP) 19.7 15.4 16.8 15.8 13.1 9.3 9.9 14.1 15.8 14.4 13.4 13.3 13.8

Prices CPI (average, % YoY) 25.2 15.9 9.4 8.0 0.6 -0.3 12.1 48.5 14.9 14.4 10.9 8.1 7.7 CPI (year-end, % YoY) 22.3 12.3 9.1 4.6 -0.2 0.5 24.9 43.3 12.4 13.7 9.5 8.0 7.5 Wage rates (nominal, % YoY) 33.7 5.5 17.6 17.7 14.8 7.9 6.0 20.5 23.6 37.1 21.0 13.5 11.0

Fiscal balance (% of GDP) Consolidated government balance -1.2 -3.8 -6.2 -1.6 -3.5 -4.7 -4.3 -1.6 -2.5 -1.5 -2.5 -2.3 -2.3 Consolidated primary balance n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a Total public debt 20.0 34.7 40.1 36.4 36.7 39.9 69.4 79.0 80.9 71.8 74.3 76.6 78.9

External balance Exports (US$bn) 67.0 39.7 51.4 68.4 68.8 63.3 53.9 38.1 36.4 43.3 46.9 47.6 49.0 Imports (US$bn) 85.5 45.4 60.7 82.6 84.7 77.0 54.4 37.5 39.2 49.6 54.0 55.1 56.5 Trade balance (US$bn) -18.6 -5.7 -9.3 -14.2 -15.8 -13.7 -0.5 0.6 -2.8 -6.3 -7.1 -7.5 -7.5 Trade balance (% of GDP) -10.3 -5.1 -6.9 -8.7 -9.1 -7.6 -0.4 0.7 -3.0 -5.6 -5.8 -6.0 -5.4 Current account balance (US$bn) -12.8 -1.7 -3.0 -10.2 -14.3 -16.5 -4.6 1.6 -1.3 -2.4 -4.1 -4.7 -5.0 Current account balance (% of GDP) -7.1 -1.5 -2.2 -6.3 -8.2 -9.2 -3.5 1.8 -1.4 -2.1 -3.3 -3.7 -3.6 Net FDI (US$bn) 9.9 4.7 5.8 7.0 7.2 4.1 0.3 3.0 3.3 2.6 2.0 1.9 2.5 Net FDI (% of GDP) 5.5 4.1 4.3 4.3 4.1 2.3 0.2 3.3 3.5 2.3 1.6 1.5 1.8 Current account balance plus FDI (% of GDP) -1.6 2.6 2.1 -2.0 -4.1 -6.9 -3.3 5.1 2.1 0.2 -1.7 -2.2 -1.8 Foreign exchange reserves ex gold (US$bn) 30.8 25.6 33.3 30.4 22.7 18.8 6.6 12.4 14.6 17.7 19.0 18.0 17.0 Import cover (months of merchandise imports) 4.3 6.8 6.6 4.4 3.2 2.9 1.5 4.0 4.5 4.3 4.2 3.9 3.6


Interest & exchange rates Central bank key rate (year-end, %) 12.00 10.25 7.75 7.75 7.50 6.50 14.00 22.00 14.00 14.50 18.00 16.00 14.00 Broad money supply (average, % YoY) 29.9 -5.5 23.1 14.2 13.1 17.6 5.3 3.9 10.8 9.3 13.2 12.0 12.0 3m interest rate (KievPrime,average, %) 18.1 21.7 10.2 11.6 20.4 11.0 17.6 24.5 20.4 18.0 n/a n/a n/a 3m interest rate spread over US$-Libor (ppt) 1353 2055 938 1020 1987 1078 1740 2453 2064 1833 n/a n/a n/a 2yr yield (average, %) n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a 10yr yield (average, %) n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a USD/UAH exchange rate (year-end) 8.05 8.05 7.94 8.04 8.05 8.24 15.82 24.03 27.10 28.10 30.00 30.00 31.00 USD/UAH exchange rate (average) 5.26 8.06 7.95 7.99 8.08 8.15 12.02 21.93 25.55 26.59 27.79 29.90 30.50 EUR/UAH exchange rate (year-end) 11.27 11.51 10.64 10.45 10.63 11.29 19.14 26.19 28.46 33.72 34.50 37.50 40.30 EUR/UAH exchange rate (average) 7.73 11.28 10.66 11.18 10.43 10.84 15.87 24.12 28.11 30.31 32.23 36.18 39.04



Real GDP (% YoY) 2.4 2.2 3.1 3.8 2.7 2.6 2.2 2.7 3.1 3.5 3.1 3.3 3.0 CPI (eop, % YoY) 16.4 13.7 13.2 9.9 8.9 9.5 8.3 8.1 8.1 8.0 7.8 7.7 7.5 Central bank key rate (eop, %) 12.50 14.50 17.00 17.00 18.00 18.00 18.00 18.00 17.00 16.00 15.00 14.00 13.00 3m interest rate (eop, %) n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a 10yr yield (eop, %) n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a USD/UAH exchange rate (eop) 26.58 28.10 26.27 26.34 28.24 30.00 29.50 30.00 30.00 30.00 30.50 31.00 31.00 EUR/UAH exchange rate (eop) 31.90 33.72 31.52 30.81 32.48 34.50 33.93 35.40 36.00 37.50 38.43 39.37 39.68



53

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