The economic recovery at risk from a second pandemic wave
Following the unprecedented economic contraction in the second quarter, recent high frequency indicators suggest that the recovery in Central and Eastern European economies progressed further over the summer months, similarly to developments in the euro area. Nonetheless, uncertainty surrounding the pace and strength of the recovery remains substantial, in particular due to the resurgence of the Covid-19 virus across the region.
While in March and April national lockdowns helped contain the virus and the region was praised as a role model, it is now among the hardest hit in the European Union. All countries have seen an upward trend in the number of new cases with an exceptionally strong second wave in the Czech Republic. This is particularly interesting as the country went from an impressive success story in the spring to a quick reversal, now recording the highest number of new cases per 100,000 inhabitants in the European Union (figure CEE1).
The adverse epidemic developments have already triggered some tightening of containment measures across the region, though they are not as stringent as during the first wave. This should, in our view, limit the economic damage compared to March and April, but some headwinds to economic activity are likely. We think it is still too early to estimate the ultimate impact of the restrictive measures as we see important changes to the measures almost daily. Hence, while we currently maintain our regional growth outlook unchanged, some update might be warranted soon.
Hungarian forint the most vulnerable currency in CEE
The adverse impact from the second wave of Covid-19 has been most visible on the regional currencies that have remained under pressure lately. The clear underperformer has been the Hungarian forint, having lost more than 10% compared to its 2019 average, which prompted the Hungarian central bank to react by unexpectedly hiking the interest rate on its one week facility by 15 basispoints to 0.75% at the end of September. Meanwhile, currency weakness was a somewhat lesser issue for the Polish zloty and the Czech koruna, both having lost roughly 4% (figure CEE2).
We see the regional pressure as being linked to overall global sentiment, which is being driven primarily by the Covid-19 pandemic. Specifically, we have seen that all the regional currencies have been significantly correlated to the CBOE volatility index (VIX) since the beginning of the year. The VIX in turn has been recently driven mainly by the uncertainty stemming from the second wave of the pandemic. The negative spillovers are not isolated to the Central and Eastern European region but can be seen across a broader set of emerging markets from Turkey to Argentina.
What is more challenging to explain are regional differences within the Central and Eastern European region. The first thing to consider is the fact that the capital outflow from the Hungarian forint was much more severe than that from the Polish zloty and the Czech koruna. Why? First, Hungarian economic fundamentals have deteriorated more significantly than those in Poland and the Czech Republic. Compared to the 2019 average, Hungarian GDP fell by roughly 14%, while Czech GDP fell only 11% and Polish GDP roughly 8.5%. Also, despite the significant drop in GDP, the Hungarian current account balance deteriorated over the course of 2020 from a minor surplus to a deficit of roughly 1% of GDP. Meanwhile, the Polish current account balance improved significantly and that of the Czech Republic remained more or less flat. The combination of a deeper contraction and growing external imbalances clearly poses higher risks for the Hungarian assets.
Second, Hungary entered the Covid-19 crisis with the most relaxed monetary policy stance and the highest inflation in the region. As a result, Hungarian real interest rates (based on realised inflation) were some of the lowest in the world at a certain point. That is why the forint has become more correlated with the Turkish lira than the Polish zloty.
Looking ahead, in our base case scenario we believe that there is light at the end of the tunnel in 2021 as far as the pandemic is concerned. As a result, we assume that all the regional currencies, including the Hungarian forint, will stabilize at some point in the future. Nevertheless, that point can still be quite far away, and in the meantime, the Hungarian forint is set to remain by far the most vulnerable in the region. Further pandemic uncertainty can theoretically lead to monetary easing in the Czech Republic and Poland, but it is far less probable in Hungary.
Hungarian’s silent rate hike
Indeed, central banks across the region react differently. Facing a significantly weaker forint coupled with high inflation, the National Bank of Hungary (NBH) delivered a silent increase of official interest rates last month as it hiked a newly-targeted rate on the one-week deposit tender from 0.60% to 0.75%. Although the move was a surprise for the market, as it came two-days after the NBH’s regular monthly meeting, the Council had actually warned that the chance of such a (tightening) move had increased because of the weakening forint. It is also worth noting that the interest rate of the one-week depo can now be changed every week within the interest rate corridor of -0.05% and 1.85%. So, if the global sentiment remains unfavourable and the forint underperforms other regional currencies, we cannot rule out further temporary increases of the one-week depo rate. This would immediately push HUF money-market rates (Bubor) higher and make the forint more attractive.
At the same time, the lower September inflation readings suggest that the inflation pressure might moderate, which means that the NBH may get closer to achieving its inflation target in 2021. This implies that the manoeuvring room for the Monetary Council increased again. While we don’t expect any change in the NBH’s monetary policy now, a chance for easing policy increased for the next months. We believe a first step might be the cut of the one-week deposit rate back to the level of the base rate (0.6%). Still, a necessary condition for the NBH’s easing action is that the foreign exchange market remains calm for a longer period and the EUR/HUF stabilizes around 350.
Czech national bank in ‘wait and see’ mode
The negative sentiment from the rapid spread of the virus and associated deterioration of the short-term outlook for the Czech economy has had a negative impact on the Czech koruna, which remains one of the crucial variables influencing the Czech National Bank’s (CNB) monetary policy stance. At the moment, the Czech koruna is less than two percent weaker compared to the expectations of the Czech central bank. Backed by the rate cuts, the weaker koruna is thus contributing to the easing of monetary conditions in the economy.
Most recently, occasional speculations that the two-week repo rate (as the main monetary-policy tool) may be further reduced have popped up. However, this is, in our view, very unlikely at the moment, given higher inflation and wage developments lately. Importantly, the Czech economy has so far more or less followed the trajectory assumed in the CNB´s forecast.
Nonetheless, the adverse epidemic developments since September may trigger a downward revision of the CNB´s forecast. The possibility of full lockdowns and a severe economic slowdown may, under certain conditions, even force the CNB to make yet another rate cut. At the same time, it is important to note that this remains a pessimistic scenario for the central bank and we believe there is a long way before this becomes the baseline scenario if at all.