From Matt Lasov, Head of EMEA Research:
“Unfortunately, some bad news out of Greece to start the new year. Things are deteriorating and it’s more important than ever to monitor events there.
In Athens, shots were fired into the offices of the ruling party including the Prime Minister’s office. Nobody was hurt but this represents an escalation in social tension. The trend is worrying as bombs were also detonated at other government offices, the homes of journalists and banks during the last week.
The economy is still shrinking under austerity and voters will ask for change one way or another. Banks are still bust and more people are losing their jobs.
Making things worse socially, the Greek government is clawing back some austerity measures for the rich and well-connected, property taxes for example, and arresting reporters who published names of those who evade taxes. The country is ripe for real social unrest. Syriza, the anti-Europe opposition, was ahead in opinion polls until the government secured the most recent round of bailout funding. When that round begins to dry up, Syriza’s case will be even stronger. Ultimately, default is a political decision.
Meanwhile, in Germany, the economy contracted more than expected, 0.5%, in the fourth quarter. With a contracting economy and an upcoming election, it’s hard to imagine that meaningful external support is on the way.
If the eurozone moves back to the brink of breakup, emerging markets that share trade and financial links, particularly in Central and Eastern Europe, will be impacted.
Companies need to prepare for a continued deterioration of the macroeconomic environment in Central and Eastern Europe through the end of 2012 and at least the first half of 2013. Demand from both the business sectors as well as the consumers in the region will slow, and public spending cuts will limit opportunity for companies selling into the public sector.
Several drivers are contributing to this bleak picture, all of them linked to the eurozone crisis.
Exports are the main culprit as most CEE economies are highly dependent on export-driven growth and the majority of their exports are destined for the eurozone. In addition, a dependence on lending from the local subsidiaries of eurozone-based banks is leading to a tighter credit market across the region and depriving already struggling local businesses from access to capital. Adding to this, the deeply depressed consumer sectors across CEE further exacerbate the slowdown in regional economies. Finally, regional governments, eager to cut public debt and budget deficits in the face of the sovereign debt crisis, are cutting spending and raising taxes, further depriving their economies of much-needed growth. Together, these trends reinforce each other, creating a perfect storm of weak growth in the region. Because regional governments are unwilling, and some are also unable, to increase spending to break this vicious cycle, CEE’s recovery is largely out of the region’s hands and instead depends on how and when European leaders find a sustainable solution to the eurozone crisis.
While these trends apply broadly to the region, there are differences. Russia, Turkey, and Poland are benefiting from the size of their economies and resilient consumer demand which will support a softer decline in growth. Russia, Kazakhstan, and, to a small extent, Ukraine will also benefit from commodity exports. However, both consumer demand and energy exports stand substantial risk of rapid deterioration of the eurozone crisis, such as may be triggered by an exit by Greece and/or Spain. In this case, no CEE economy will be spared and the starting point of the recovery will be delayed even further.
Interview with Matt Lasov, head of EMEA research for Frontier Strategy Group:
“There is a lot of tough talk coming out of Germany after the government approved the Spanish bank loans. Some officials are essentially challenging Greece to leave, claiming that the Greek problem is ring-fenced. It’s mostly rhetoric designed to rile up domestic voters. We are very skeptical that we’ll see German-led action to force Greece out. Politicians are simply jockeying for power as the domestically unpopular Spanish loans created a political opportunity. Forcing Greece out still has the potential to destabilize thinly-capitalized German banks and the broader European financial system.
The next signpost to watch is the upcoming Troika visit. Greece has closed only 12 public agencies from a target list of 120. At the same time, the Greek government is expected to ask for a budget deficit cut extension that will cost the Troika an additional 30-50 billion Euros. This will be hugely unpopular with taxpayers across Northern Europe.
Markets are not taking the news well and, as a result, Spanish 10yr yields shot to a record 7.5% today. A bit more under the radar, 2yr yields shot up to 6.4%, so even rolling over short-term debt will be painful and difficult. When yields spike in Spain on the back of Greek news, it highlights the continued interconnectedness of the European financial system despite German claims that Greece is ring-fenced. A disorderly Greek exit still has the potential to create bank runs and bond strikes in Spain. The market’s response to Italy has been more measured. 10yr yields increased to 6.4%.”
Interview with Matt Lasov, Head of EMEA Research for Frontier Strategy Group
“The risk of default and devaluation in Europe is still high. Bailout discussions focused on Spanish banks buy time and businesses should use this time to set plans in place to protect themselves against a Spanish exit from the euro.
So what’s changed in Europe since the last update? Not much. The crisis is playing out exactly as anticipated. The likely scenario remains deep recession. The risk of eurozone break up remains high and businesses should continue to plan for this. Greece is off the rails, waiting for elections in the middle of June to determine its fate inside or outside the eurozone. Meanwhile, Spain entered a full-fledged banking crisis that requires a coordinated European bailout.
The bailout for Spanish banks should buy time and avoid a run on banks in the immediate term. It will not fix the structural issues that will plague Spain in the medium term.
It is important to note that the bailout deal is not done. Spain will still have to accept the terms of the agreement, which will require harsh austerity and a transfer of fiscal sovereignty to Germany. Can the Spanish government force this on its people, especially when Prime Minister Rajoy ran on a platform guaranteeing that this would not happen? If Rajoy can push it through, how long will Spain be able to weather a cycle of harsh cuts to public services while unemployment remains at record highs?
Even if the bailout goes through, and we expect that it will, Spain will still require cost cutting of 30-40% to compete globally. This will be immensely painful whether it is done slowly over a decade, as every labor and government contract is renegotiated at competitive rates, or through a quick but highly disruptive devaluation. As cost cutting continues, the economy will shrink, and more debt will go bad because there are fewer available revenue streams that can be used to pay it off. Another bank bailout will be required to clean up the remainder of the debt overhang and the cycle will continue. Some estimates show an additional $300bn euro gap in the medium term. The current package amounts to $100bn euro.
We have seen this movie before. The cycle playing out in Spain is exactly what happened in Greece. Europe stepped in with bank bailout money to avoid imminent implosion of the member state. In exchange for funding, Greece accepted austerity measures which reduced the size of its economy. While the economy shrank, the debt burden with long term maturities stagnated. Debt to GDP ratios soared and Europe called for further austerity. The result for Greece is higher unemployment and extreme social pressures that are leading to an exit.”
Business sentiment in China is weakening due to continued political drama, falling industrial production, and declining growth expectations from export-dependent provinces such as Guangdong and Zhejiang. Nevertheless, northeastern markets such as Tianjin and Liaoning continue to see significant investment from multinationals, suggesting that growth prospects for the region remain strong.
For more detailed insight on major trends on a provincial level in China, find our latest analyst headlines below:
Interview with Matt Lasov, Head of EMEA Research for Frontier Strategy Group
“The crisis in Spain is accelerating faster than expected. Again, it’s all down to the banks. While everyone’s attention is on Greece, Spain is quietly struggling to pull off the Bankia bailout. Spain planned to provide Bankia with $24bn government debt that Bankia could post at the ECB in return for loans. The ECB said they would not accept that as collateral. Now Spain is back to the drawing board because it’s unclear where $24bn cash will come from. They only have $12bn cash left in their bailout fund. They can issue debt to fund the gap, but who is going to lend to them at this point? The solution is probably to force a merger with a healthier bank. This will buy a bit of time, but will compound the problem. Can a bank like Santander really handle a large, toxic portfolio?”
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The fall of the Romanian provisional government on April 27th was the latest indication of rising anti-austerity sentiment across Europe. In the past several months, just in CEE governments have fallen in Slovakia, Slovenia and Romania, with the disintegrating Czech governing coalition barely surviving a no-confidence vote last week. However, these are not the only countries where popular dissatisfaction with the deteriorating macroeconomic environment is on the rise. The incumbent government in Croatia lost to the left-leaning opposition in the latest elections, while the pro-European Serbian government stands the real possibility of being voted out of office in favor of the leftist and nationalist opposition in next week’s elections. The Party of Regions in Ukraine, facing elections in October, is already increasing public spending to stave off its sliding popularity. Even Poland’s just-reelected government has taken a significant popularity hit in response to the austerity measures it introduced immediately after returning to office.
As CEE voters are making their preferences for less austerity clear, the resulting political instability is not all bad news for MNCs in the region. First, the political instability in CEE is giving local consumers breathing room by delaying the introduction and implementation of higher taxes that would reduce consumer spending power. Coupled with weakening inflation, this creates the opportunity for moderate improvement in consumer growth in CEE that would benefit MNCs in the FMCG space.
Second, anti-austerity sentiment in CEE is part of a broader European backlash against belt-tightening. CEE’s new governments are more likely to push for a strategy of growing out of the eurozone crisis, the only viable way for Europe to break the vicious circle of high debt and low growth in which it has been trapped. In giving in to their populist tendencies, CEE’s new governments may well push Europe toward the most viable way out of protracted recession.
Finally, CEE’s political turmoil is weakening local currencies, creating opportunities for cheap investment. With local valuations depressed due to the eurozone crisis and CEE governments aggressively seeking to attract foreign investors, MNCs are well-positioned to acquire local assets at a discount that will be compounded by currency depreciation in response to CEE’s turbulent political landscape.
As exports and consumer demand slow and regional governments seek to reduce spending, growth is weakening across the region and a difficult year is ahead for both B2B and B2C MNCs. GDP growth forecasts will likely be revised further down as CEE economies struggle with continuing volatility and recession in the eurozone. Kazakhstan and Russia continue to benefit from high energy prices, but remain vulnerable to an oil price decline
- Bulgaria: The economy will slow in 2012, but a conservative budget will act as a buffer against an external macroeconomic shock
- Croatia: Croatia is in for a challenging 2012 that will bring austerity measures, pain for local consumers, and possibly a recession
- Czech Republic: Avoiding a deep recession in 2012 is possible if there is clear progress on the eurozone crisis and the German economy remains strong
- Hungary: The government will struggle to regain investor confidence as its controversial policies are undermining market trust in Hungary
- Kazakhstan: MNCs can expect continuity in government policies and populist measures in 2012
- Lithuania: The liquidation of a major local bank threatens to offset the budget this year and may mean more austerity measures
- Poland: MNCs pursuing investments in Poland are well-positioned to capitalize on the country’s undervalued currency
- Romania: Romanian consumers remain deeply pessimistic about the economy’s prospects, a trend that will impact consumer goods MNCs
- Russia: Economic performance will slow only moderately as the government will support high consumer spending ahead of the elections
- Serbia: The key driver for Serbia’s growth this year remains the economic performance of the eurozone
- Slovakia: The consumer outlook remains negative through 2012 as any new government would have to cut public spending
- Turkey: Economic growth will slow gradually over the next several months
- Ukraine: Growth will slow this year and could decline sharply if commodity prices drop as a result of the recession in the eurozone
Original Article in MarketWatch
Matt Lasov, director of global research at Frontier Strategy Group, said the emerging markets’ performance in 2012 depends on their relationship to the euro zone.
“The euro zone is in a recession that is likely to get worse,” Lasov said. “We see a two in three chance that there is a breakup of the euro zone in 2012 — most likely Greece leaving.”
And “success for emerging markets will be determined by linkages to the euro zone,” he said.
“The clear outperformers in the short term are India, Indonesia, and Sub-Saharan Africa,” according to a research note from Frontier Strategy Group, referring to those markets as having “low linkage” to the euro zone. “These markets are characterized by rapidly growing domestic demand and diversifying economies that are creating middle class growth” and they have limited trade relationships with Europe.
The Middle East and Latin America are linked to Europe because of trading in commodities, the note said, referring to these markets as having “medium linkage” to the euro zone. “Reduced European demand for oil will impact state revenues, but most markets have more than enough reserves to weather a crisis.”
Russia, meanwhile, is “positioned to be the biggest underperformer,” the note said. “Oil exports to Europe are driving Russia GDP growth more than ever before,” and as oil prices fall below the $110 per barrel built into the Russian budget, “Russia will enter deficit.”