Slow growth and high inflation

Central and Eastern European (CEE) countries – many of them being small open economies – have been subject to similar external shocks and developments as the euro area economy. Most recently, falling energy prices and the prospects of a reopening of the Chinese economy as well as the easing of supply chain disruption has lifted some of the risks to these export oriented, energy-intensive economies. This improvement is reflected in the bottoming out of most sentiment indicators. However, CEE economies are still headed for a severe slowdown of growth (stagnation), while many of them are expected to have already entered a technical recession in Q4 2022. Nevertheless, we have revised growth expectations for 2023 slightly upward for most economies leading to average growth for 2023 at 0.7%, 0.3%, 0.3% and 0.6% for Bulgaria, Czech Republic, Hungary and Slovakia, respectively.

Inflationary pressures persist in many of the CEE economies as core inflation has been the main driver of inflation over the last year. The more prominent role of core inflation in these economies is related to their large openness and the strong pass-through of energy and food price developments. As pipeline inflation pressures remain important, certainly in those economies where price caps are possibly being lifted (e.g. Slovakia), and wage pressures are likely to persist, we expect a relatively slow deceleration of core and headline inflation. For the reasons discussed above, our inflation forecasts for the region remain well above those for euro area countries. As current inflation readings are well in double digits, we expect average inflation in 2023 to remain well above the 5% threshold at 10.5%, 7.6%, 17.5% and 10% for Bulgaria, Czech Republic, Hungary and Slovakia, respectively. Inflation risks remain tilted to the upside.

The strong koruna – are the gains towards the region sustainable?

As globally inflation is decelerating, energy markets ease and the Chinese economy is poised to reopen, financial markets have switched to a risk-on mode. Risk-off dynamics that put CEE currencies under pressure have abated and reversed. This provided some relief or even support for these currencies. One case in point of the impact of these risk sentiment reversals is the koruna which appreciated considerably and abruptly against the euro to values close to 24 koruna per euro.

Compared to the 2019 average, the Czech currency gained more than 7% against the euro, while the Polish zloty lost 8.5% and the Hungarian forint is more than 18% weaker. Behind the koruna´s strength are undoubtedly the massive foreign exchange reserves (still around 50% of GDP). Also, the willingness of the CNB (in both its old and new composition of the board) to actively use these reserves to defend the Czech currency as well as its hawkishness in the earlier phase of the inflation surge played a role.

However, such (non-fundamental) abrupt appreciations also come at a cost. As a consequence of the string koruna appreciation, price competitiveness deteriorated in the Czech Republic over the past years despite strong wage growth in the neighbouring countries. The overall loss of competitiveness is reflected in the significant appreciation of the real effective exchange rate in the Czech Republic compared to the rest of the region (figure CEE1 and CEE2).

However, neither worsening relative price competitiveness nor higher input prices have so far lead to strong erosion of the profitability of the corporate sector. On the contrary, the Czech corporate profit dynamics even accelerated in the third quarter of 2022 (over 15% year-on-year growth), clearly outpacing wage dynamics, but well below inflation. The profit rate has thus risen significantly since last year lows, now reaching 46.6% (profit as a share of value added). Also, the cost competition has not so far been a significant issue for the external balance. The current account has deteriorated significantly this year and is about to end in deficit close to 5% of GDP. Nevertheless, this is mainly due to higher (energy) import prices and supply chain problems. Underlying demand for the Czech exports seems to be still relatively strong.

Even so, worse price competitiveness could hit profitability and export dynamics in some sectors, if the relative strength of the koruna persists. And that is one of the “weak fundamentals” that lie behind our rather sceptical mid-term view on the koruna exchange rate. Despite the very positive start to the new year and hardly predictable near term volatility, we see the koruna slightly weaker by the end of this year.