2013 will not be a year of recovery in CEE


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.

Conditions in Greece Worsening – FSG Analyst Insights

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%.”


Recession in Europe, Driving Risk of Breakup – FSG Analyst Insights


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.”

Emerging Markets Outlook Bright in 2012

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.”

The Sovereign Debt Crisis in Emerging Markets (Part I)

What happened?

In 2008, banks stopped lending as they were forced to use capital to absorb losses from deteriorating investment portfolios. When lending dried up, business struggled, industrial production contracted, and jobs were lost.

Job loss drove the consumer into a deep recession. When the consumer lost its means to spend, banks found themselves in more trouble. Consumer-related debt securities holding everything from mortgages to credit cards to auto loans began to default, driving the deepest recession since the 1930s.

Governments stepped in as lenders of last resort to break the vicious cycle, but many governments were already overleveraged. As bad credit worked its way through the system, markets ultimately turned on indebted governments believing that governments would not be able to repay debt.

Enter the sovereign debt crisis

Markets revolted first against governments on the periphery of Europe because it was clear that those governments would run into solvency issues with no credible plans for economic growth. Ireland, Greece, and Portugal subsequently received bailouts but are still in trouble. Italy is on the brink and there is not bailout package on the table large enough to solve that crisis. Spain is next.

The crisis is not a Greek problem or an Italian problem. The crisis is a problem that impacts all of Europe as well as markets globally. Leading European banks based in Germany and France hold tremendous amounts of bad sovereign debt as well as derivatives on that debt. Much of this is not marked to market, so banks currently do not have to recognize losses. However, the event of a technical default will force banks to recognize losses that they are not capitalized to absorb.

A technical default is the worst-case scenario because it will disrupt the banking system, dragging Germany, France, and the broader global economy into recession. The only way to mitigate the impact of an EMU breakup is if the European Central Bank (ECB) preemptively recapitalizes banks, something Germany is opposed to because it fears inflation.

Regardless of the scenario that plays out, Europe is headed for recession and a breakup of the EMU. The only potential solution is a massive debt monetization program that would be led and funded by Germany through the ECB. However, this is becoming increasingly unlikely as policy heads the opposite way. On Monday, November 14th, German Chancellor Merkel’s party voted to allow EMU members the right to remain in the EU free trade zone; even they left the monetary union. This is a critical first step in preparing the mechanisms necessary to support a breakup of the EMU.


The Problem in Italy Lies in Politics, Not Economics

BerlusconiBerlusconi’s exit may mark the beginning of the breakup of the European Monetary Union (EMU), changing the business environment in Europe and markets globally. The problem in Italy lies in the country’s politics, not its economics; if the political class demonstrates they will do what is necessary, catastrophe can be averted. And over the past half century, Italy has often done the right thing (usually after exhausting all other options). The country’s politicians turned a ruined country into the world’s 8th largest economy, outwitted the most powerful and genuinely popular communist party in the western world, and entered the Euro, to name just a few accomplishments. Unfortunately, the challenge before them today is far greater and far less conducive to political machinations. The country has to decide whether it will be a competitive and dynamic economy or a larger version of Greece; the health of the world economy, and the future of the Euro, hang on the balance.

Germany Structuring Path to Euro Exit for Italy, Greece

German Chancellor Angela Merkel’s party voted today to provide a means for Euro-zone markets to voluntarily exit the Euro without losing access to the EU’s free trade zone. This move confirms that Germany is not willing to save the Euro in its current form and will begin to put in place additional mechanisms that will lead to exits from the Euro.

Retaining free trade with the rest of the continent is the key issue for markets like Greece, Italy, Portugal and Spain who would become more competitive overnight with a devalued currency and access to open borders.

If accepted by the broader EU, the move will make an exit easier for troubled markets, but it may also put undue pressure on the banking systems in Germany and France. Any exit would cause default, meaning that German and French banks have to absorb losses on bad debt and associated derivatives. A preemptive strategy to recapitalize banks will be required if Germany is to protect itself while paving the way for weaker markets to leave the Euro.

Greece likely to leave Euro

“If Greek voters vote no, Greece will default and drop the Euro as its currency, switching to a “New Drachma.” Frontier Strategy Group sees a greater than 50% chance that Greece will leave the Euro.”

Markets reacted strongly this morning to Prime Minister George A. Papandreou’s announcement that Greece would hold a referendum on the EU plan for aid. The surprise announcement put the future of the Euro firmly in the hands of Greek voters who are likely to say no to aid for additional austerity. Share prices for European banks, who hold large amounts of Greek debt, plunged 8% and broad European markets were down 4% in early trading.

The Greek government used the referendum as a policy maneuver to buy time to negotiate more favorable terms with EU creditors. The play may backfire as Greek voters are tired of austerity, unemployment and ineffective government. If Greek voters vote no, Greece will default and drop the Euro as its currency, switching to a “New Drachma.” Frontier Strategy Group sees a greater than 50% chance that Greece will leave the Euro.

The referendum will most likely take place in January. As a result, companies have two months to put contingency plans in place for Greece. Companies choosing to remain in Greece will need to develop strategies to finance suppliers and distributors as credit from Greek banks will dry up. Opportunistic companies are considering using Greece as an export hub, as leaving the EU would likely devalue the local currency by 50%, making Greece an attractive long-term play from a cost point of view.

Impact on emerging markets

Greece leaving the Euro increases the likelihood of a double dip recession across Europe. European banks will take major losses in the their bond portfolios. Markets will also view a Greek exit from the Euro as a precedent for similar action in Portugal, Spain and potentially Italy. Exposure to derivates on bad debt is still unknown, compounding the uncertainty that will cause lending to dry up in both Western and Eastern Europe. Last time Europe went into recession, CEE markets, Russia and Turkey suffered disproportionately. This time, many emerging markets are more linked than before.

While many emerging markets will be impacted by the crisis, leading companies have already identified winners and are prioritizing resource allocations for those markets. India, Indonesia and Africa are set to be the biggest winners as domestic demand is driving robust growth in those markets. The Middle East and Brazil will also carry on through the crisis although they have higher linkages to developed markets because of commodities exports. China, on the surface, is positioned to outperform, but bad domestic debt and a slowing manufacturing sector are causes for concern.

Sovereign Debt Crisis in Greece – What it Means for EMEA Emerging Markets


Austerity measures are not a solution to structural problems in Greece. What is at the root of the sovereign debt crisis? What are the risks? How will it impact emerging markets? Frontier Strategy Group Practice Leader, Matt Lasov answers these questions and more in an interview with EMEA analyst Martina Bozadzhieva.