June 2010 Can Central and Eastern Europe Resist the Debt Crisis?

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1 May 2010 June 2010 Can Central and Eastern Europe Resist the Debt Crisis? After having hurt Greece and other Euro Periphery countries, the wave of Sovereign Debt fears has reached the Central and Eastern European region as Hungary was put under pressure to reassure markets who remember how sensitive Central end Eastern European countries have been to the 2008 Credit crisis while most of these countries tentatively emerge from this deep recession.

2 Can Central and Eastern Europe Resist the Debt Crisis? Citi analysts observe that Western Europe s turmoil has affected financial markets in Central and Eastern Europe (CEE) worse than anywhere else. CDS Spreads of CEE countries have indeed been much more sensitive to events in Western Europe than CDS Spreads of other Emerging Markets since the beginning of the year while the Hungarian Forint and the Polish Zloty have been the worst-performing emerging markets currencies during the six week period starting on 1 April, regardless of whether the USD or EUR are used as a base currency. Citi analysts estimate that the Neighbourhood risk is increasing and they envisage 3 possible contagion mechanisms: Financial, Economic or Thematic The Financial contagion mechanism works via the wide openness of CEE countries financial markets to Western European banks and more particularly to Greek Banks. Citi analysts observe that with the exception of Russia, Turkey and Ukraine, European banks retain high levels of exposure to CEE as a percentage of country GDP. This creates vulnerability for economies that remain dependent on the willingness of foreign creditors to remain exposed to Europe s periphery. Citi analysts observe that since the Lehman crisis, foreign banks were net takers of repayments in 8 of the 10 largest CEE countries. They think that further reduction in risk appetite is likely if European banks are faced with a growing capital shortage. However, Citi analysts estimate that the effect of financial contagion could be minimized by the fact that CEE isn t credit-dependent these days. They observe that CEE countries proceeded to substantial current-account adjustments in 2009 which reduces credit demand for the economy as a whole. In addition, Citi analysts think the pre-lehman growth model based rapid domestic spending growth built on plentiful credit-availability has broken broke down. In the aftermath of that breakdown, credit demand and domestic consumption have sharply decreased and Citi analysts expect that external demand will be the critical driver of GDP in many countries. The Economic mechanism is the mechanism by which doubts about the Euro Area s growth prospects can have a negative impact on both exports from CEE and capital flows to CEE. Given the evolution towards a more export-driven economic growth, a weaker Euro Area growth could constitute a new kind of external shock to the as only two countries, Turkey and Ukraine, sell less than 50% of their exports to the Euro Area. However, assessing CEE s vulnerability to economic contagion is complex. There is indeed a share of CEE s exports to Western Europe Germany in particular which don t depend on final demand in the EU, but are part of a production process which depends on final demand in third countries. Since the Euro s recent depreciation, on balance, might support net exports, then CEE s vulnerability may be smaller than overall exports to Western Europe numbers suggest. Finally, the thematic mechanism relates to the concerns about high debt/gdp ratios in Western Europe that could in turn trigger doubts about CEE countries with similar problems. Citi analysts estimate that, with the exception of Hungary, the Thematic contagion should be less of a risk to CEE. Citi analysts observe indeed that even in countries where the debt/gdp ratio rose very sharply between 2007 and 2009 Latvia, Ukraine, Romania the starting point was a very low public debt burden and remain far from the average level of the Euro Area. Only Hungary, with a debt/gdp ratio of 80% compares to the average level of the Euro Area. On balance, Citi analysts estimate that a deepening of Euro Area woes would have negative consequences for CEE, but that none of the contagion mechanisms highlighted sound loud alarm bells for CEE at the moment given the absence of public debt concerns, the lower reliance on credit and the potential benefit from a weaker Euro. Source: Citi Investment Research & Analysis, Emerging Markets Macro and Strategy Outlook May 2010

3 Chart 1: S&P 500 Index Chart 2: MSCI Europe Index ,52% 2 20,61% ,20% -2,30% -1-4,96% -1,74% ,83% ,10% -4 United States Mounting threats from Europe Euro-Area More divergences expected Evidence has mounted that strong profits have prompted new spending and hiring that will support healthy labour income as government supports fade, Citi analysts say. Citi analysts have left their GDP forecast for 2010 unchanged at 1.1.% YoY, but they expect the growth divergence between the fiscally most strained countries, which have announced additional austerity packages for this year, and the less fiscally strained countries to widen. Citi analysts estimate that Consumer and business spending will compensated lagging construction and state and local government woes. Housing markets have shown signs of steadying in recent months and the small business sector appears to be catching up to the broader upturn. In order to contain the contagion from the Greece sovereign, the European Council agreed on a European Stabilisation Mechanism worth 750 billions and the European Central Bank (ECB) has been entitled to purchase sovereign debt on the secondary market. Citi analysts estimate that this programme averts the risk of an imminent default of a Euro Area However, they think that renewed risk aversion and eroding liquidity member-state but is not likely to prevent a restructuring of the Greek debt. stemming from events in Europe may pose threats to financial stability necessary for continued U.S. economic recovery and suggests that monetary policy may need to remain focused on maximum accommodation longer than they anticipated. Citi analysts believe the European Central Bank will keep rates unchanged until end of 2011 given the outlook for weak growth and inflation in the coming years, and to avoid liquidity pressures. Citi analysts observe that Inflation is slowing to 1%, reflecting the sharp relative decline in housing costs and massive economic slack. However, reviving income and stable inflation expectations should help steady Strengthening recovery and positive operational leverage may drive a robust rebound in corporate earnings. Citi analysts are expecting 2010 & 2011 European earnings growth of 20%+. pricing beyond the near term. However, Citi analysts feel that there may be better structural growth Citi analysts observe that sentiments have turned to panic and that US equities are largely undervalued. They observe that 100% of the current market valuation implies that there is almost no long-term projected earnings per share growth being assumed by the investment community opportunities in emerging markets equities and better cyclical growth opportunities in the US than those offered by exposure to the domestic economy. Thus they continue to prefer companies with international exposure. currently.

4 15,00% 1 Chart 3: MSCI Asia Pacific 11,21% Chart 4: MSCI Emerging Markets Index 25,00% 22,72% 2 5,00% -5,00% -1-15,00% -2-9,84% -5,79% -25,00% -24,46% -3 Japan Bank of Japan likely to keep policy rates on hold through 1H11 The economy may continue to grow at a pace above the potential growth rate in quarters to come, under a combination of a continued uptrend in exports, a pickup in business and housing investment and a modest improvement in labour conditions. In Citi s view, the cyclical mechanism in which export growth drives activity could remain intact in 2010, thanks to the resilience in other Asian economies. Meanwhile, companies appear to remain cautious about increasing personnel costs and this is likely to limit a spillover to household income but may push up corporate profits strongly this year. Citi analysts expect the Bank of Japan (BOJ) to maintain the current policy rates until late Asia Pacific Reduced inflation pressures Asia's recovery is broadening, with sustained final demand recovery in the US and domestic demand revival in the region, according to Citi analysts. Meanwhile, inflation has recently almost unanimously surprised on the downside. Citi analysts think subdued demand in advanced economies has inadvertently slowed the inflationary upturn in Asia, allowing Asian policymakers to be less aggressive in unwinding its very accommodative policies. In particular, Citi analysts favour the North Asian markets of Hong Kong, 15,00% 1 5,00% -5,00% -1-8,75% -15,00% -5,36% -1,39% Emerging Markets Gradual exit of recession in CEEMEA While other Emerging Markets may continue to normalise monetary conditions through policy rate hikes in the coming months, hikes may be barely visible in CEEMEA 1, where in many cases rates are still high in the wake of the crisis-related need for monetary tightening in The biggest hike this year could come through in Turkey, where rates remain unsustainably low, in Citi s view. Latin America s recovery appears on track and Citi analysts believe that rising inflation, higher inflation expectations and smaller output gaps should prompt most of the tightening cycle in the region. Most Latin American currencies are likely to continue benefiting from the global recovery, commodity prices and capital inflows in the short term. In CEEMEA, Citi still forecasts currency appreciation (particularly South African Rand (ZAR) and Polish Zloty (PLN)), despite the ongoing concerns in the Eurozone periphery. Citi analysts believe 2010 is likely to be a year of more modest gains in MSCI Latin America as markets wait for corporate earnings to catch up to the high valuations at end They are overweight Brazil and Mexico. Despite a number of global concerns, Citi analysts remain positive on CEEMEA over the medium term given that economic data has been beating expectations, earnings forecasts have been rising and valuations remain undemanding. They are more cautious on the near term and acknowledge a potential higher vulnerability to the Sovereign credit crisis in the Euro Area. They are overweight Russia. Korea and Taiwan. Sector-wise, they believe that banks have an inevitable role in all economic recoveries. At the same time, valuations look attractive. 1. CEEMEA is the collective term for Central and Eastern Europe, Middle East and Africa.

5 4,00% Chart 5: Currencies (vs USD on 1 month) 2,00% Currencies -2,00% 2,76% High-grade corporate debt expected to outperform US Treasuries Citi analysts expect interest rates to be range-bound with tighter monetary measures beginning in the second half of the year, boosting term premiums. -4,00% -6,00% -8,00% -7,43% -4,82% Euro GBP JPY Currencies Citi analysts estimate that the cyclical underperformance of the Euro Area against the US combined increased risk aversion due to debt woes in the Euro Area could drive the Euro to test the level of 1.15$/ in the coming months. US Corporates While further narrowing is likely to be modest given that spreads are approaching long-term equilibrium levels, Citi analysts continue to expect corporate debt to outperform other high-grade sectors. Meanwhile, High yield spreads are anticipated to continue grinding tighter over time as positive technical factors and improving fundamentals support performance. Euro Bonds Fiscal burdens in peripheral Euro zone nations present key risks to higher rates in Germany. In the UK, Citi analysts favour short duration exposure as outsized fiscal burdens and inflation pressures dampen performance prospects. On the longer term, Citi analysts estimate the equilibrium rate at 1.33$/ which makes the Euro strongly undervalued at the current levels. The Euro could find support later in the year on increased risk appetite and focus on US own deficit and debt challenges. The plan of the new UK government is to cut fiscal spending and raise taxes to make a significant early reduction in the budget deficit in order to avoid the risk that the UK is downgraded and markets force adjustments on the UK. A lower debt path, better credit rating and an improved current account balance should all boost sterling s long term value. In the short to medium term, however, in which we investors have to operate, this mix of easy money and tight fiscal tends to weaken currencies Citi analysts expect the Japanese Yen to broadly follow the trend of the US dollar. They estimate that with both Government and Central Bank more confident of the economic outlook, new policy initiatives are unlikely for now meaning that recent attempts to drive the JPY weaker are unlikely to continue. The risk of weaker Euro Area growth and its potential negative impact in CEEMEA currencies, especially in Central Europe markets, has increased. However, the majority of Citi analysts short term forecasts in CEEMEA continue to be bullish versus forwards. This is particularly the case for the Ruble and the Zloty. Emerging Market Debt Citi analysts are constructive on Asia and Latin America credits as improved liquidity and risk appetite persist. 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