Welcome to the U.S.-Ukraine Business Council

From Timothy Ash at the Royal Bank of Scotland (RBS), London

Countries covered: Ukraine, Bulgaria, Czech Republic, Croatia, Estonia,
Hungary, Latvia, Lithuania, Slovakia, Serbia, Poland, Romania, Russia, & Turkey      

RBS EM Strategy Update | Quick CEE Country views
By Timothy Ash, Head of CEEMEA research
Royal Bank of Scotland, 135 Bishopsgate,
London, UK, Tuesday, March 3, 2009                                   

LONDON - Please find attached a quick review of Emerging Europe to see how each economy is being impacted by the current de-globalisation/de-leveraging process. It is evident herein that no one is immune, despite politicians’ protestations otherwise, and attempts to “decouple” from the broader regional malaise.                                                                                      

Countries covered: Bulgaria, Czech Republic, Croatia, Estonia, Hungary, Latvia, Lithuania, Slovakia, Serbia, Poland, Romania, Russia, Turkey & Ukraine.  Apologies for the length.  We will post individual country views on the RBS website.                                                                         

(-) Single-commodity reliance is high - Ukraine is ultimately a play on global metals prices, as metals account for 40% of exports. The collapse in metals export prices and volumes have imparted a huge impact on the economy.

(-) Ukraine followed the regional trend of high levels of foreign borrowing, driven on to an extent by foreign banks entering the market and driving to take market share. The nominal US$ stock of external debt quadrupled between 2004 and 2008 to US$108bn, albeit this stood at just 60% of GDP by the end of 2008. However, given the subsequent correction in the UAH, and the marked decline in GDP, this could well rise to 100% of GDP by the end of 2009.

Short term/M&LT debt falling due in 2009 are estimated at US$45-50bn, which has raised concern over external financing – only partially covered via the extension of a new US$16.5bn IMF SBA in October.

(-) Alongside the weight of debt amortisations falling due, Ukraine ran a CAD of 6-7% of GDP in 2008, reflecting buoyant import demand and rising energy import costs. We think the UAH correction, and the huge deflation in domestic demand/lack of credit, will narrow the CAD in 2009, even perhaps putting the balance in the black. 

(-) The economic downturn, and currency correction has exposed key frailties in the banking system, weighed down by too much foreign debt (around US$40bn total external liabilities), and suffering rising NPLs (15-20% by some estimates), exposing weak capital bases of banks.

While foreign ownership is high (now approaching 50%, given VEB’s take-over of Prominvestbank) doubts are emerging over foreign parents’ commitment to the country/region and their willingness to refinance/recapitalise their local operations.

(-) Public sector indebtedness is low (< 30% of GDP at present) but rising with bank recapitalisation costs/IMF borrowing, while public finances are currently under pressure from a falling off in budget revenues as the economy slows abruptly (GDP expected to decline by 8-10% YOY this year). The budget deficit could widen to 5%+ this year, and doubts remain over its financing.

(-) The political environment remains strained, with the relationship between erstwhile coalition partners, the president and prime minister, close to breaking point, and this undermines efforts to form a united policy front.

SCORES on the DOORS: The UAH has already lost more than 50% of its value over the past 6 months, 5Y Ukraine CDS has, meanwhile, widened by over 3,000bps, with the market already assuming a high probability of default. Ukraine has suffered multiple rating downgrades, with S&P recently cutting its rating to CCC+ - in the same triple-C category now as Pakistan and Ecuador.

 All this is despite a new US$16bn IMF programme, albeit the latter is in limbo. We actually think though that risk is more than adequately priced in by the market, and do not expect a sovereign default in 2009.

Poland – Needs to scrap idea of early ERM-II                                    
Most people had assumed that Poland would be relatively immune from the current crisis given:
(+) Public finances were in reasonable shape, with public sector debt/GDP ratios ~ 55%, & a budget deficit of < 2% of GDP;                                
(+)  Similarly modest external debt/GDP ratios of ~ 60%;
(+) The zloty floats, with inflation targeting leaving policy makers with room to manoeuvre. Early membership of ERM-II, expected in mid-2009, was expected also to underpin the currency.

But the crisis has revealed vulnerabilities:
(-) A large nominal external financing requirement (nominal $$ roll-overs are key in this crisis – look at Russia), with a CAD of US$29bn, ST debt of US$78bn, and M&LT debt amortisations of US$30bn. FX reserves have dwindled from US$82bn to US$59bn. Also note a suspect negative figure of US$19bn on the BOP from “errors and omissions” which need to be financed and perhaps give an overly positive “spin” to the current account position.
(-) Weak technical market position, with a huge long zloty position, buying into the ERMII story, and Polish corporates estimated to be facing PLN15bn in losses on various FX option positions.
(-) With FX volatility across CEEMEA, the government’s obsession with early ERM-II entry does not seem such a clever move now – it just creates another level for the market to aim for. The fact that the NBP is lukewarm over the issue just suggests policy disharmony, undermining sentiment more generally.

SCORE ON THE DOORS:  Zloty down 33%, 5Y CDS wider by 350bps over the past 6 months to just below the 400bps mark at present. Real GDP growth is expected to slow from the previous 5-6% trend to at best 1% in 2009. Unemployment is rising rapidly and expected to hit 12% by mid-2009. The budget deficit target is likely to be exceeded, forcing a mid-year revision; probably too early to talk about an IMF programme, but never say never. Its A2/A- ratings have held rock solid thus far, but we would not be surprised if the rating agencies cut just for caution.

Hungary – Time just ran out
Every economist I know covering Hungary was amazed that it survived so long, despite running large twin deficits way back from 2003/2004. The fact that it was n’t rolled over then reflected to a large extent the stellar work of its debt management agency that cultivated a loyal European investor base that kept the faith, remembering perhaps the halcyon reform days post Bokros (1996 -2000) when Hungary was the market’s darling, overtaking the Czech Republic in that respect.

Since 2003/04 the government has actually done a commendable job in curbing the budget deficit, via implementation of aggressive austerity measures. The problem is that this all came too late as the bulk of its foreign investor base no longer has appetite for CEEMEA risk.

Too many negatives:
(-) High euroisation of bank loan books (corporate and retail) leave Hungary hugely vulnerable to sustained FX weakening. It’s a difficult balancing act for the NBH on the exchange rate front, and frankly we struggle to see the exit strategy. Talk of early ERM-II membership is simply fanciful for a country with such large imbalances/external liabilities; while the EU/ECB is unwilling to cut new entrants any slack when the Eurozone is facing its own problems. The economy needs more flexibility in monetary policy to enable the NBH to cut official rates (which remain high at 9.5% nominally).
(+) The €20bn EU/IMF programme agreed in the autumn of 2008 bought the authorities’ time, but it does not resolve the basic contradictions at the heart of exchange rate policy, and have really failed to do much to lift investor sentiment. Meanwhile, the economy just plummets to new lows, further undermining investor sentiment, and public finances in the process.
(-) The general government deficit was cut from 9.3% of GDP in 2006, to just 3.4% of GDP in 2008, but given the dismal growth outlook which is likely to impact on the revenue side, the deficit is expected to edge up. The ratio of public sector debt/GDP is also expected to increase from an already high ratio of 66%.
(-) Latest MOF calculation suggests a current account deficit of 7.5-8% of GDP in 2008, albeit they suggest that this could halve in 2009 given the deflation in domestic demand – somewhat complicated though by the region-wide collapse in exports. Nevertheless, it still suggests a significant external financing requirement, and continued reliance on official financing/pressure on the HUF.
(-) Hungary led the regional dash to borrow in FX, and as a result the country has an unsustainable burden of external liabilities, equivalent to ~ 100% of GDP. The country’s total external financing requirement in 2009 is probably in the US$30-35bn range, albeit this is now largely covered via official financing. Official reserves stood at US$31.6bn at the end of January, reflecting IMF/EU disbursements in November. Worryingly though, reserves still fell by over US$2.3bn in January.

SCORE ON THE DOORS:  The HUF has been in the forefront of the CEEMEA FX sell-off since last summer, losing 25% of its value against the €, albeit surprisingly outperforming the “floating”” PLN. FX weakness forced the NBH to hike rates late in 2008, and this risk remains as concern over household/corporate FX borrowing remains. Clearly the inflexibility on the exchange rate front, leaves the economy set to dip deeper into recession, just aggravating the government’s problems on the budget financing front.

Hungary has already suffered multiple rating downgrades, and its investment grade rating must be under threat in the current environment; Fitch has placed its BBB-rating on negative outlook. Real GDP contracted by 2% in Q4, but with industrial output declining by 23.3% YOY in December, it seems highly likely that the economy will suffer a severe downturn in 2009, likely minus 3-4%. Note that 5Y CDS on Hungary is now back to the highs seen just prior to the IMF deal last fall, at just short of 600bps.

Romania – similar story to Hungary, but without the hefty burden of public sector debt.

Most of the story for Hungary, and indeed Croatia, we could repeat for Romania, albeit the latter country’s key benefit still (from the Ceausescu era) is a much lower base of external debt. The basic problem though is excessive overseas borrowing, particularly by households and corporates, which leaves banks’ exposed to credit risk as the exchange rate comes under pressure to adjust to close wide external imbalances. This also makes the management of monetary and exchange rate policy that much more difficult.         
Romania has shown clear signs of overheating in recent years, evidenced by:
(-) A wide and indeed widening current account deficit; which is thought to have reached around 12-13% of GDP in 2008; and double digit for the period 2006 – 2008.
(-) From a very low base the ratio of external debt/GDP rose to around 55% as of the end of 2008. Around one third of external debt is thought to be short term, which with M&LT debt amortisations falling due, and the CAD above suggests an external financing requirement of as much as US$60bn in 2009; BNR reserves stand at around US$33.5bn.
(-) The government has revised down its budget target for 2009 to 2%, after initial projections had suggested the deficit could extend to as much as 5% of GDP. Even the above forecast may prove optimistic given the rapidly slowing domestic economy. Given Romania’s history of poor industrial relations, the government may struggle to impose budget cuts/austerity in practice, which suggests a somewhat strained outlook for relations with the IMF – history repeating itself?
(+) Rolling the above external liabilities will clearly be difficult in the current global environment; hence in March the government announced that it was in negotiations with the IMF over a new funding arrangement. Previous Romania-IMF relations have been very chequered, with previous governments struggling to meet IMF conditionality; this suggests that the Fund is likely to be much more specific/tough in agreeing terms. Romania, like Hungary will hope to supplement IMF monies with cashfrom the EU/ECB, et al. We would expect any programme to be in the US$20-30bn range.

SCORES on the DOORS: The RON lost around 20% of its value against the € over the period since September, but the BNR is now trying to hold the currency at around the 4.30 level, clearly with an eye on limiting the impact of FX weakening on corporate/household borrowers in FX. 5Y Romania CDS has followed the rest of the market wider, currently trading around 725bps, around 680bps wide over the year but around 100bps wide of Bulgaria but flat on Estonia.

Romania became the first EU-member state to lose its investment grade rating in October when S&P downgraded the sovereign to BB+. Further downgrades are expected. As with the rest of the region, the real economy has been heavily impacted now by the global crisis. Thus after growing at a trend rate of 8-9% over the first 9 months of 2009, real GDP growth is thought to have slowed to just 3% in Q4, as industrial output posted huge declines of 11.5% YOY and 18% YOY in November and December 2008. Official forecasts still suggest 2-3% growth in 2009, but given current trends, and exchange rate rigidities we think the economy will be lucky to avoid falling into outright recession in 2009.

Russia – Finally I’ll be able to afford a decent hotel in Moscow
Had been most peoples’ safe haven trade – how wrong we all were!

The walls of the Kremlin had appeared to be shored up by:
(+) Sound public finances – huge budget surpluses (~6-7% of GDP), next to no public sector debt (<10% of GDP), plus US$220bn+ in the Stabilisation Fund.
(+) A seemingly strong external financing position, with a current account surplus of 7% of GDP, US$600bn in FX reserves (20+ months of import cover), and a modest external debt/GDP ratio < 40%).
Ultimately the shock troops were provided by:
(-) Plummeting oil/commodity prices, which account for 80% of exports; likely worsening the trade account by US$170bn YOY in 2009.
(-) Ratios don’t matter in this crisis – nominal US$ roll-overs do, and Russia has US$100bn+ in ST debt, plus US$30-40bn in M&LT debt maturing in 2009; add in a likely current account deficit in 2009 and this suggests an onerous external financing requirement in 2009. Refinancing external liabilities falling due has thus far proved very difficult.
(-) Tech over bought rouble appreciation story – US$40bn+ in this trade via portfolio investment, which left in Q4 2008.
(-) Low level of dollarization, which accelerated flight when push came to shove – US$130bn left in Q4 2008 via capital flight.
(-) A rigid exchange rate regime which provided an easy target for the market to gun for.
(-) Lots of political noise/concerns over corporate governance – all the chickens ultimately came home to roost from the good time, when policy maker in Russia thought they could boss investors around (Yukos, BP-TNP, Mechel, Georgia).
(-) Weak banks – Over the past decade policy makers baulked from cleaning up the banking sector, even after the murder of the former deputy governor of the CBR sent a clear message that action needed to be taken.

SCORES ON THE DOORS:  Rouble weaker by 35% against the basket and 5Y CDS wider by 600bps over the past 6 months. Real GDP growth is set to go into reverse, from 6-7% growth trend over past decade, to minus 5% perhaps in 2009. The budget is set to post a deficit of 8-10% of GDP, with the current account going into deficit in 2009. The CBR has, meanwhile, lost at least one-third of its FX reserves, and despite the managed depreciation reserves are still falling.

Croatia – Where are those holiday brochures for Dubrovnik again?
Croatia is re-known for its drugs (Pharmaceuticals) companies, banks and beaches, but shares with the region in terms of its key vulnerabilities including:
(-) Wide current account deficit (~10% of GDP), reflecting real effective exchange rate appreciation, and too much external borrowing to fund domestic bank/credit expansion.
(-) Its external debt/GDP is amongst the highest in the region, at ~ 90%, with private sector external debt standing at 67% of GDP. Unfortunately a lot of this exposure is by households/corporates who have been encouraged to borrowing in Euro/CHF by foreign banks aggressively expanding in the region.
(-) A heavily managed exchange rate leaves the economy vulnerable in the current environment; as with Romania and Hungary; the CNB is worried that a large exchange rate correction will force higher delinquency rates on household/corporate borrowers, hiking NPLs in the banking sector hence undermining their capital bases.
(+) To its credit, the government has reigned in the budget deficit in recent years, capping it at around 2% of GDP, with the ratio of public sector debt/GDP ratio to around 42% at present.

SCORES on the DOORS: Kuna only down 4% against the €, but at the price of the loss of a big chunk in FX reserves (US$3bn+). The economy is, meanwhile, expected to contract by at least 3% in 2009, with the budget deficit expected to push up to 3% of GDP. Unemployment rose to 14.5% in January. Ultimately we expect Croatia will join the never ending list of countries going to the IMF for a bail-out. Its investment grade rating (Baa3/BBB-/BBB) has to be under threat. 5Y CDS is wider by around 500bps over the past 6m. The crisis could jeopardise Croatia’s bid to join the EU by 2011.

Czech Republic : Begs to be different, but at what cost
Most analysts are probably amazed by how badly impacted Czech markets have been by the current crisis. Key credit strengths include:
(+) Floating exchange rate, with inflation targeting in theory gives the CNB considerable monetary policy flexibility to negotiate through the current storm hitting CEEMEA.
(+) FX weakness should help provide a cushion to the economy, limiting the decline in real GDP growth to perhaps 0-1% in 2009, which will somewhat cushions the increase in NPLs in the banking sector, as will the limited borrowing in FX.
(+) The budget deficit has been constrained to 1-2% of GDP in recent years; albeit as the economy slows, this could double in 2009. General government debt/GDP is, however, very low at ~ 26%. 
(+) The current account deficit is modest by regional standards, at 3% of GDP for 2008; albeit the trend was to a sharp deterioration (from 1.5% of GDP in 2007). Note though that in 2008 the CAD was fully covered from net FDI inflows. There remains some uncertainty how the failing off in demand in the EU will impact on the BOP going into 2009.
(+) Relative absence of borrowing in FX. Low local interest rates, and a higher domestic savings rate, have acted to limit borrowing by households/corporates in FX, limiting the roll-over risks which are impacting other economies in the region. The country has one of the lowest ratios of external debt/GDP at ~ 43%. We estimate the total external financing requirement in 2009 as short of US$30bn, which is still more than covered via official FX reserves (US$36bn+).

SCORES on the DOORS: The Czech crown has lost around 20% against the euro over the past 6m. Investors have also been buying 5Y CDS on the sovereign; it has widened by 250bps+ over the past year; but is still seen as a cheap (risk) regional proxy. And, just proving that no economy is immune to the current scale of the crisis facing the global economy, real economy indicators released in recent months have suggested a marked slowdown is under way even in the hallowed Czech Republic.

Industrial output, for example, declined by 17.4% YOY in November, with industrial sales off by a similar amount. Retail sales were down by 6.3% YOY in the same month. Indicators of business and consumer confidence have, meanwhile, hit new lows and are highly negative. The Czech Republic appears highly vulnerable to the slowdown in the EU, given its large manufacturing/auto base.

Slovakia – Chitty, Chitty, bang, bang!
Slovakia is an auto-hub for the region, and its early EMU entry came “just in time”, as it saved it from concern over FX roll-over risk on euro-denominated liabilities in banks and beyond. Suppose the question remains though as to its ability to compete given in effect its new fixed exchange rate.
Slovakia does have underlying strengths though:
(+) Reasonably sound public finances, with a budget deficit/GDP ratio of 2-3%, and a general government debt/GDP ratio of < 30%.
(+/-) Suppose the current account deficit of 5-6% of GDP does give some indication of competitiveness albeit with euro-membership the external financing risk has lapsed.

Despite the above the real economy, as with the Czech Republic, has been significantly impacted by the global slowdown: Industrial production declined 16.8% YOY, with sales down 17.5% YOY, while industrial and consumer confidence have also both dipped to record highs. Slovakia’s huge auto industry, relative to the size of the economy, has left it acutely vulnerable to the collapse in global demand for autos. Government officials are talking about real GDP growth slowing to 2.4% in 2009, which appears very optimistic, albeit this would still be down from the trend 8% growth achieved in recent years.

SCORES on the DOORS: Given limited (well no) scope to express a view via FX, pressure has been felt on CDs, with 5Y widening close to 200bps over the past year; albeit it remains the tightest with Slovenia in the region.

Latvia – And remind us again why we have a fixed exchange rate?
Latvia is currently at the eye of the storm which is rolling across Eastern Europe. Unfortunately it has all the headline grabbing negatives for the region:
(-) A fixed exchange rate regime, which means that any adjustment to close the wide external financing gap has to come from a deflation of domestic demand, suggesting that Latvia is going to be beset by a deep and prolonged recession. Real GDP declined by a bunker (or more accurately currency-busting) busting 10.5% YOY in Q4 2008, and the government is now suggesting a full year decline of 12% in 2008.

The extremity of the collapse in economic activity, despite an IMF/EU bail-out, raises concern that politicians will simply not be able to withstand the likely social/political upheaval which holding to the current regime in the current hugely inclement global environment is likely to bring.

Politicians will surely begin to ask why they are holding such fixed exchange rate regimes, when they no longer offer any prospect of delivering growth. One argument in defence of the current regime is that devaluation would be counter-productive, as it would just push those households/corporates who borrowed in FX into default, undermining asset quality of the banks.

However, holding to the current fixed exchange regime risks deflating the domestic economic to such an extent that these borrowers will not be able to meet their liabilities anyway, e.g. if we see borrowers lose their jobs. It also implies some burden sharing from the broader economy, to those who arguably borrowed in excess. Further, we would also expect that politicians, and the population at large will be begin to ask the question as to why foreign banks are not being made to take more of the cost of the adjustment through an exchange rate adjustment.

Presumably there is concern here that by devaluing, and in effect passing the cost of the adjustment to foreign owned banks, Latvia will undermine its long run goal for membership of the single currency zone. The message from the EU/ECB though is that this is now far off for countries on its periphery.

(-) Huge stocks of external debt, with Latvia having one of the worst ratios in the region – over 150%. With around US$16bn in short term debt falling due, and given scheduled debt amortisations, and a likely current account deficit, the country faces an external financing requirement of well over US$25bn, 5 times FX reserves.
(-) The current account deficit reached in excess of 20% of GDP in 2006-2007, and while it narrowed somewhat in 2009 is still too large too be financed. 
(-) As the economy has slowed budget revenues have slowed abruptly, and there are now suggestions that event the 5% deficit target for 2009 agreed with the IMF could be exceeded by wide margin (perhaps as much as 8% of GDP). Budget spending was already cut by around 6% of GDP as a condition of the current IMF programme, and more budget austerity to bring the budget back in line would just add to the problems in the real economy/increase social/political unrest. General government debt/GDP ratios were modest at the onset of the crisis (13% of GDP in 2008) but will likely rise abruptly with the disbursement of IMF/EU monies, and given the wide budget deficit.

SCORES on the DOORS: Given limited opportunity to express negative views on the exchange rate via thin local markets, the negative trade has been to buy sovereign protection; assuming the currency peg fails, and the state’s public sector debt ratios get pummelled via a decline in nominal €/US$ GDP and given the likely high bail-out costs from banks. 5Y CDS has subsequently widened out by over 1,000bps over the past year. Latvia now trades wide of Iceland by around 100bps; remarkable given that it received an IMF programme late last year. Latvia, meanwhile, became the second EU-member state to lose its investment grade status by S&P last month, and further downgrades appear inevitable.

Lithuania/Estonia/Bulgaria/BiH – We really are different to Latvia; if you say it enough you might begin to believe it

All three have similar problems to Latvia albeit on a smaller/more manageable scale – Bulgaria’s current account deficit remains well above 20% of GDP. Public finances are better in Lithuania, Estonia and Bulgaria – the latter has a large fiscal reserve and hence is close to being a net public creditor from a public finance perspective – and all three benefit from lowly public sector debt/GDP ratios (Bulgaria = 14%; Lithuania = 18%; and Estonia = 5%).

Bulgaria/Estonia both have very high ratios of external debt/GDP though of around 100%, Lithuania’s is lower at around 80%. Estonia & Lithuania also have very modest FX reserve cover (around 3 months); Bulgaria’s is higher at 5-6 months.

We generally assume that a move to devaluation in Latvia would refocus attention on other fixed exchange rate regimes across the region. We think that Lithuania would increasingly be a focus of market attention, due to geographical proximity and weak FX reserve cover. Bulgaria/Estonia might be able to ride it out longer, due to their strong public finance positions, but in the current environment even these regimes are unlikely to hold.

SCORES on the DOORS: All have seen 5Y CDS widen aggressively over the past 12 months, as investors increasingly assume that fixed exchange regimes will inevitably be rolled over.

Bulgaria has widened by around 550bps over the past year to 600bps, while Lithuania is priced at 800bps, wider by 750bps over the year.

Lithuania posted a 2% YOY contraction in GDP in Q4 2008, while with industrial production falling by 5.6% YOY in January, suggests a full year GDP contraction in 2009 of 3-4%; again a marked slowing on the trend over the past decade.

Estonia by contrast saw GDP decline by a whopping 9.4% YOY in Q4, perhaps reflective of the importance of the port of Tallinn to its overall GDP; and hence dependency on trade. Industrial output, meanwhile, declined by20.7% YOY in December, beaten by a 26.8% YOY decline in January. In Bulgaria real GDP growth slowed to 3.6% in Q4, half the prior trend, and with industrial output falling by 8.3% YOY in December, the economy will do well to avoid falling into recession in 2009.
Turkey – defying gravity, don’t knock it
Turkey would have been one credit that the universal consensus had been to be most affected by the current global credit crisis. Key vulnerabilities include:
(-) Penchant for political high drama – the headscarf et al, with AKP-secular tensions ever near the surface.
(-) Assumed wide external financing needs – CAD of US$40bn+ on a 12m moving average basis, with ST debt and M&LT debt amortisations falling due of US$100bn+. Net-FDI inflows, which have recently covered 2/3 of the CAD are slowing rapidly. FX reserves cover only half the external financing requirement. 
(-) A large stock of foreign portfolio funds invested at the start of the crisis (US$70bn+) and assumption that these funds would quickly head to the exits.
(-) A still relatively high nominal stock of public sector debt (40% of GDP, i.e. US$391bn or so), with hefty annual roll-over ratios. As the economy slows, indeed goes into recession, we expect concerns over budget financing to increase; unchecked the budget deficit could top the TRY50bn mark – given trends on the revenue side early in the year.

As events have transpired Turkish FX/credit assets have tended to out-perform the region, which can perhaps be explained away by:
(+) Turkey is a large net energy importer and its BOP looks set to greatly benefit from the decline in global oil/energy prices; rough rule of thumb, each US$1 change in the oil price saves Turkey US$400m in energy import costs, which indicates US$15-18bn in savings to the BOP.
(+) Turkey went thru a brutal banking crisis in 2000/2001, with the sector being significantly restructured as a result. It came into the current crisis in reasonably good shape, i.e. reasonably well capitalised/profitable. The sector did join the CEEMEA credit party, but relatively late, and from a low base, hence it is not as exposed on the asset quality side as the rest of the region. That said, all this depends on the scale of the downturn in the real economy, and the stability of its deposit base (thus far solid).
+) Unlike many economies in the region, Turkey entered the current crisis with FX deposits near record highs (US$105bn) – partly due to perceived domestic political risk in 2007 & 2008 (the e-coup/elections in 2007, then the AKP party closure/headscarf case in 2008). Since the summer locals have been selling FX into lira weakness, underpinning the currency and broader confidence. These sales have totalled US$20-25bn, which has been a key source of current account financing.
(+) While PM Erdogan is playing hard to get with the IMF in advance of local elections at the end of March, all and sundry knows that a deal with the IMF will be quickly concluded if push comes to shove. Much of the groundwork appears to have already been concluded. For the IMF, Turkey remains a large (debtor) and indeed has been a poster-child of reform for the fund post-2001. Turkey’s geopolitical significance also suggests strong support from key IMF stakeholders for IMF monies to be made available to Turkey if the need arises – there has been talk of a US$25-30bn programme.
(+) The CBRT runs a floating exchange rate regime with inflation targeting. The FX weakness since September/October should help the adjustment on the current account, while the aggressive easing by the CBRT has certainly kept local bond investors invested.

SCORES on the DOORS: The lira did follow other CEEMEA currencies weaker in the immediate fall-ut from the collapse of LEH, but has since remained relatively stable/outperformed its peers. Similarly Turkey 5Y CDS while widening over the year by around 250bps, to 500bps or so still shows considerable outperformance on its peers. Over this same period Russia 5Y CDS, arguably a stronger credit when viewing its credit matrix, widened by 600bps.

And Turkey now trades inside six EU member states; while previously it was considerably wide of any EU member state. Industrial output fell 17.6% YOY in December, and with exports falling 35% YOY in February, this suggests a deep recession. Official projections of 4% real GDP growth in 2009 appear pie in the sky, we would expect real GDP to contract by at least 2% in 2009.

Serbia – trying to stay under the radar
Prudently Serbia went to the IMF early, agreeing a US$518m precautionary arrangement back in November 2008; as yet undrawn.. There is now discussion of boosting this to a formal Stand-by arrangement for US$2.5bn.

Serbia’s problems are again symptomatic of the region, albeit perhaps on a smaller scale – foreign banks/consumer credit came relatively late to Serbia.
(-) A wide current account deficit; the CAD widened by 38% YOY in 2008 to US$8.7bn or 17.4% of GDP. Net FDI covered only around one-third of this amount (reflecting failed bids to sell key assets, including RTB Bor, and JAT), with debt financing covering the bulk of the balance. Clearly resort to debt financing from the market at least is not now an option, leaving the country dependent either on a combination of exchange rate adjustment, official financing, a draw down in FX reserves and/or a huge deflation in domestic demand.
(-) A weight of external debt, mostly private sector, largely driven by foreign-owned banks expanding rapidly in the country. As of the end of 2008 the external debt/GDP ratio stood at 65%, relatively modest by regional standards, but nevertheless a relatively high share of short term debt, has raised concerns over roll-overs. Obviously herein the concern is whether foreign owned banks will continue to refinance/recapitalise their local operations, as asst quality deteriorates both through the general economic slowdown, and as consumers of credit (mostly in FX) are increasingly distressed as the currency corrects to help close the external financing gap. NPLs are expected to rise.
(-) The government will likely struggle to limit the central budget deficit to the planned RSD57.8bn, given that both growth and inflation are expected to come in below target. Budget revenues were already 16% lower YOY in January, suggestive  of a much larger deficit. Given the lack of a developed domestic bond market, and limited appetite for a foreign issue, the government will either need to reign in the deficit or seek additional financing from official creditors; we assume that this will be a major focus for negotiations over beefing up the existing IMF program. A budget revision is currently planned for March; the original IMF programme committed the government to cut the general government deficit from 3% of GDP to 1.75%, but the government is likely to push for some relaxation from the Fund, given the severity of the external shock being imparted on the economy. A plus for Serbia, is that given recent Paris/London Club restructurings, the ratio of public sector debt/GDP is modest at only around 25%.

Working in Serbia’s favour:
(+) Serbia has little foreign portfolio money invested, reflective still of the relatively under-developed state of its local capital markets; this leaves it less vulnerable to capital flight (unlike Russia).
(+) The dinar floats as the NBS maintains an inflation targeting regime, which has allowed the NBS to cut rates (75bps in January) even despite FX weakness – limited pass thru expected from exchange rate weakening to inflation. The exchange rate adjustment should also help to close the external financing gap, and indeed this already appeared evident from merchandise trade data for January, which showed a near halving in the monthly deficit, as imports dropped by 37.5% YOY, outpacing the 23.8% YOY decline in exports).
(+) Serbia benefits from having a relatively strong techno-reform administration with good collaboration between the government and NBS (the same cannot perhaps be said of the situation in Ukraine or for that matter Poland). Given Serbia’s recent nationalist past, and continuing concerns over management of the Kosovo issue, the current “liberal” regime headed by Boris Tadic, continues to be backed/financed by Western governments.

SCORES on the DOORS: The dinar has lost around 20% since last summer, albeit the NBS does operate a floating exchange rate regime, and hence still managed to cut its benchmark 2 week repo rate by 75bps in January, albeit only to 16.5% one the highest rates in the region. 5Y CDS is trading up around the 900bps mark, which is probably 600bps north of where it was 6 months ago. The impact on the real economy has nevertheless been severe, with exports down 24% in January, and industrial output falling by 17.1% YOY. The government has already cut its real GDP growth assumption for 2009 from 3.5% to 0.5-1%, but we suspect Serbia will do very well to avoid outright recession.
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