Emerging Markets Insights

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.

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Interview with Matt Lasov, Head of EMEA Research for Frontier Strategy Group

Spain –Take today’s banking stress test results with a grain of salt because the hired consultants were not permitted to audit the banks directly and instead could only review Spanish central bank records. These are the same records that showed Bankia earning a profit, not a multibillion euro loss. Bizarrely, the government also hired the big four to audit the banks directly, but those results are not set to be released publicly.

Regardless of the opacity surrounding the stress test, one thing we have learned is that the capital needed after stress tests has tended to be 2x or 3x the stated amount. This was the case in the US (take Citi, or Bank of America for example) and has been the case in Europe. Be wary of the results.

Italy – There are concerns that Berlusconi will use an anti-austerity platform to reshape government and regain power. Berlusconi has been completely out of the political spotlight as his reputation recovered. He chose these comments to mark his return:

“The day we stop supporting this technical government, we will recover a lot of votes”

“If we continue on with the policies of Signora Merkel,” Mr. Berlusconi said referring to German Chancellor Angela Merkel, “We will end up in a worsening recessionary spiral. This is really the wrong policy.”

Berlusconi still has a tremendous amount of power in Italy and is the leader of the party that backs Monti’s technocratic, unelected government. Any moves in the opposite direction will roil markets, as the Italian government loses credibility.

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Interview with Matt Lasov, Head of EMEA Research for Frontier Strategy Group

Politically, there is zero will to allow Spain to default but markets have moved faster than politicians every step of the way. It’s very difficult to view European politicians as credible at this point, the markets certainly do not. Remember, default is always a political decision (or in this case indecision). There are policy tools available to fix this crisis, debt monetization for example. The challenge is in getting 17 eurozone governments to agree when they are beholden to domestic voters, though they share a supranational currency. As of now there is no path to solve this fundamental challenge in a timely manner.

Here’s what we know about Spain – and why we think risks are very high:

The story for Spain is bust banks and a dose of social unrest

CDS spreads show 40% chance of default, up from 30%

Youth unemployment at 50% with zero public benefits (there is no available cash for extended unemployment etc…) is a recipe for disaster

12-month yields at 5% and 10-yr at 7% is not sustainable from a funding point of view – borrowing at these rates only compounds the debt crisis.

With high borrowing costs and the 100bn euro loan, Spain’s government debt to GDP jumped to 90%, it was at 60% last year. The credit crisis was effectively transferred from Spain’s banks to its government – a government that lacks cash and the typical policy toolkit – ie printing money, devaluation.

Spain’s bond purchases are fully subscribed but there is zero foreign participation which will be necessary to bring in rates. The only buyers are Spain’s bust banks which are now reliant on government funding. This is a less-than-virtuous circle that cannot last.

Various eurozone bailout funds have the cash to string Greece along, but not Spain/Italy. A true bank recapitalization would overwhelm the size of current facilities.

Timing:

We’ll know more about the willingness of policy makers to credibly solve the problem by June 30^th. At that point the European summit will have ended, the G-20 will be over, and Greece will hopefully have been extended. The pendulum will have hopefully swung from harsh austerity to the balanced deleveraging approach.

If things have not made progress by June 30th, we will need to talk about broader eurozone contingency planning. Policy makers are running out of chances and markets don’t give mulligans.

Meanwhile in Greece:

Looks like a weak coalition of pro-Europe parties will govern Greece.

Greek parties have told the Greek people that they will modify bailout terms but simultaneously told European leaders they would not ask for this.

Driven by the cycle of austerity, social pressures in Greece are too high to bear and coalition parties realize they will need to soften austerity if they are to stay in power for any period of time.

This coalition will not be long lasting. Aside from historic domestic political competition between the parties, the coalition’s legitimacy now depends completely on Europe’s willingness to modify loans. Germany has not indicated it is willing to do this in a meaningful way.

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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.”

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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?”

What do you think? Leave a comment and join the conversation.

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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.

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Explosive deterioration of its relationship with Israel. A trip of the post-Arab Spring Middle East. Turkey’s foreign policy is generating quite a lot of attention in the Middle East these days.

Beyond its political implications; however, the policy of courting key Middle Eastern countries like Egypt also has a serious domestic driver: Turkey’s economy is charting precarious waters.

Turkey has been struggling with a rising current account deficit driven by strong domestic demand. The rise in household consumption has been financed by capital from Europe, making Turkey increasingly vulnerable to an outflow of short-term capital as European economies continue to struggle.

The other pillar of Turkey’s economy – exports, is also threatened by the potential of a Eurozone recession. With over 50% of Turkish exports going to the EU, Turkey is particularly vulnerable to a drop in demand from such key countries as Germany, Italy, and Spain. FSG Monitor estimates that a US-EU recession would lead to a 2% drop in Turkey’s GDP in 2012. The projected decline may not be as dramatic as in other countries in the region, but compared to Turkey’s Q1 2011 11.6% GDP growth, followed by 8.8% for Q2 2011 (Turkey had the highest H1 2011 GDP growth in the world), it’s very significant.

In this unstable environment, the Turkish government has announced it will seek to promote export-oriented domestic production. But this strategy will only work if there is enough demand for Turkey’s increased exports. With the European economy in a shaky state, Middle Eastern markets will be increasingly instrumental to Turkey’s economic stability. Currently, the Middle East is the second biggest regional market for Turkish exports, accounting for 20% of the country’s exports, plus another 4.9% of exports going to North Africa.

Turkish businesses are clearly seeing the writing on the wall and are aggressively seeking expanded influence in the Middle East, as evidenced by Prime Minister Erdogan’s large business delegation on his recent trip to Egypt and his promise to increase trade between the two countries to US$5 billion.

In this context, MNCs should expect Turkish competitors to aggressively pursue opportunities in the post-Arab spring markets. As we already discussed, MNCs with overly risk-averse strategies in the region can fall behind regional competitors with a greater risk appetite. It also means, however, that MNCs with Turkish partners can use these relationships in support of strategic expansion in the MENA region, benefitting from the good will Turks are enjoying among the region’s populations and leadership.

In this context, the role of Turkey as a manufacturing hub for the Middle East and North Africa region is becoming increasingly attractive, not just to MNCs but also to the Turkish government itself. As a result, MNCs with local production facilities meant for export to the region are well-positioned to lobby the Turkish government for additional incentives and support.

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