CEE countries vulnerable but still showing sound growth;

Inflation emerging as a key challenge

The global environment for economies is currently characterised by low economic growth in the US and euro zone, strong concerns about inflation and high levels of uncertainty and volatility in the financial market. “This international environment is clearly testing the economies in Central and Eastern Europe, though so far the region appears to be resilient” so Debora Revoltella, CEE chief economist of UniCredit Group. The usual growth drivers remain constant in CEE and the UniCredit Group economists continue to forecast an average yearly growth rate of 4.6 % in Central Europe , 5.1 % in South Eastern Europe (SEE) and the Baltics and 6.0 % in Broader Europe in the period from 2008 to 2010.

The consumption in the CEE countries is fuelled by rising household incomes and declining unemployment. Nevertheless high inflationary pressure and tighter monetary conditions are resulting in moderation. Moreover, households in the region are now coping with more stretched balance sheets than in the past, because they have increasingly been financing their consumption with debt, making them more sensitive to potential shocks. However, the CEE region remains competitive and selected industries might even benefit from decisions by international companies to maximize the return on their past delocalization strategies.

The international environment reveals long-term domestic weaknesses

“It is quite clear that due to the international environment vulnerabilities in the CEE region exist. In particular financing domestic growth with international savings has now become an issue”, says Revoltella. In recent years, most countries in the region have relied on external savings to finance their growth. Rising current account deficits were financed by foreign direct investment, but also by external debt. The banking sector has also played a role, with strong lending growth – one of the main drivers of the retail and investment boom – being largely financed from abroad. In 2007, the region accumulated roughly € 100 bn in international debt, while the banking sector almost doubled net access to foreign funding. Countries whose banking sector is more dependent on foreign funding are the Baltics, Ukraine, Kazakhstan and Romania and countries that most need to finance the current account are the Baltics and Southeastern Europe.

Inflation problem becomes particularly pressing in CEE

“Driven by rising food and oil prices, inflation is a global problem. However, in CEE it seems to be particularly pressing, given the weight of energy and food on the household consumption basket,” so Revoltella. In addition to the international component, CEE countries also face a number of domestic inflation challenges, e.g. remaining market inefficiencies, price liberalization and simple price convergence towards Western standards. Labour market conditions are also not supportive, with unemployment generally in decline and labour scarcity fuelling wage increases. Furthermore easy monetary conditions in some countries contribute to the high inflation. Thus, the struggle against inflation will remain a priority and finding the proper instruments will be extremely challenging in most of the countries.

Baltics are cooling rapidly and South Eastern Europe is vulnerable

The economic outlook in the Baltic countries clearly deteriorated since the beginning of 2008. This results from rising macroeconomic imbalances, tightening credit conditions and overheated real estate markets. Especially in Estonia and Latvia the slowdown seems to be proceeding faster than previously expected, with an estimated GDP growth for 2008 of 0.1 % in Estonia and 2.0 % in Latvia. Alone Lithuania’s economy appears to be more resilient at the moment, with an expected GDP growth for 2008 of 4.7 %.

The bursting of the property price bubble is quick, particularly in Latvia, given the fact that the development of the real estate market observed in recent years was less smooth than in the other two Baltic states. In Riga for example the apartment prices fell 25 % from the beginning of this year to June. Signs of stagnation in the housing market have also increased in Estonia, after the property sales fell by 30 % in the second quarter 2008.

With high current account imbalances, strong dependency of growth on external savings and strong inflationary pressure, SEE countries are facing similar challenges to the Baltic states. Thus, the financing of the large current account deficits remains a key issue to monitor. However, the economists of UniCredit Group believe that while some moderation in growth should be expected in SEE, based on the overall booming economy recorded so far, no hard landing scenario, like the one which is now materializing in the Baltics, has to be expected. “This because firstly the real estate market in SEE is much less inflated than in the Baltic countries, secondly because the economic structure in SEE is much more diversified and domestic competitiveness remains and thirdly, though the SEE countries experienced a credit boom, it occurred much earlier in the market development phase”, explains Revoltella. The expected GDP growth rate for 2008 in these countries thus remains at a quite high level: the highest in Romania with 6.8 %, followed by Serbia with 6.2 %, Bulgaria 6 %, Bosnia-Herzegovina with 5.8 % and Croatia 4 %.

About UniCredit Group

With total assets of more than €1,000 billion, ranking among the top financial groups in Europe, UniCredit has a presence in 23 countries, with over 40 million clients, round 10,000 branches and some 180,000 employees.

In the CEE region, UniCredit operates the largest international banking network with over 3,900 branches and outlets, where more than 80,000 employees serve about 27 million customers. The Group operates in the following countries: Azerbaijan, Bosnia and Herzegovina, Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Kazakhstan, Kyrgyzstan, Poland, Romania, Russia, Serbia, Slovakia, Slovenia, Tajikistan, Turkey and Ukraine.