Current Account Deficits – Shrink to Fit

Until last summer, easily available cheap credit (mostly in FX in some cases) and strong income gains were fuelling a consumption binge across CEEMEA, which translated into C/A deficit widening to very high levels, well above those that preceded the Asian Financial Crisis of 1997. A drying up in credit availability, substantial currency depreciation and slower income gains will result in much lower current account deficits across the region this year and next, in our view. The dramatic shrinkage in funding gaps should be accompanied by severe recession almost everywhere, with collapses in consumption and imports already taking a heavy toll on tax revenues. In essence, as the IMF has also observed, what was a BoP problem has now become a fiscal issue. In addition, while C/A deficit gaps have dropped, some countries are seeing much smaller inflows or outright outflows in their financial accounts, losing reserves as a result: this is the case for instance in the Baltics, Bulgaria, Romania, Poland and Ukraine.

In this note, we survey the ongoing BoP transformation across CEEMEA. In Central and Eastern Europe, which had seen C/A deficit to GDP ratios reach double-digit levels in some cases, the adjustment is well underway, especially in the Baltics and the Balkans; in Turkey, a collapse in imports due to weaker consumption and favorable terms-of-trade (ToT) effects is bringing the C/A gap to the lowest level in five years. In South Africa, by contrast, we think that the improvement will be pretty marginal in 2009/10, as imports show resilience and ToT effects are overall negative.

Despite the drop in external funding needs, we remain quite cautious on CEEMEA currencies, on account of the weak growth backdrop and the rise in external debt that IMF support implies. In Central Europe, we still prefer PLN and CZK to HUF and RON on fundamental grounds. In the Baltics, currencies are not liquid enough, so we think it will be best to play the devaluation theme via sovereign CDS. In Turkey, we think the TRY could remain close to its current levels between now and year-end, as the IMF deal and local investor buying offset the weakening pressures coming from lower rates and external debt payments (see Turkey Economics: Positioning Is Still TRY Supportive, April 8, 2009). In South Africa, we maintain our overall bearish view on the rand, and see USD/ZAR heading to 10.00.

Central Europe and Balkans: Imports Collapse as Credit Dries Up

The adjustment in current accounts in Central Europe is happening primarily via trade (slower imports), but income deficits are also going to fall sharply, as foreign corporates see their profits shrink (so both reinvested earnings and dividends will drop). Some country details below:

Czech Republic: The latest data (February) show a narrowing of the 12-month current account due to some large current transfers from the EU. However, details show that the massive income deficit, which is entirely responsible for the C/A gap in the Czech Republic, is narrowing. This is because multinationals’ profits earned in the Czech Republic are set to shrink this year and next, and therefore dividends and reinvested earnings (both C/A outflows, though reinvested earning are ‘automatically financed’ as they are also recorded as FDI) will drop dramatically. Note that income outflows in January-February are already at the lowest level since 2004. This trend should become more obvious in the summer, when these outflows usually peak. We think that the current account deficit should trend much lower, towards 1.5% of GDP by year-end from 3.3% currently. On the funding side, EU inflows and FDI should still comfortably cover the gap. Overall, the Czech external accounts should continue to compare favorably with the rest of the region.

Hungary: Hungary’s latest C/A data are for 4Q08 and as such are pretty dated. The large 8.4% (4qma) C/A gap was almost entirely due to income outflows (8.1%), mostly dividends and reinvested earnings. On the financing side, Hungary has experienced severe portfolio outflows (both bonds and equities), but the surge in ‘other’ inflows (IMF and EU money) should be more than sufficient to plug in the funding gap. Looking ahead, as in the Czech Republic, the income outflows are likely to drop this year as multinationals’ profits get squeezed. Meanwhile, the first few months of trade data for 2009 show that imports are collapsing faster than exports, so the overall trade balance is already improving slightly. Overall, it looks likely that the C/A gap will drop dramatically, to around 4% of GDP by year-end. 1Q data (out on June 30) should already begin to show clear signs of improvement. While Hungary’s financing gap is set to narrow, its debt stock remains a key source of concern: external debt stands at 113% of GDP, on an upward trend (the highest in EMEA outside the Baltics); government debt looks set to approach 80% of GDP this year, again at the top end of the range.

Poland: The C/A gap has narrowed by nearly one percentage point over the last few months, mostly as a result of a lower trade deficit (collapsing imports) and smaller income outflows. At 4.7% of GDP on a 12-month basis, the current account looks likely to continue to decline for much the same reasons as elsewhere (to around 3.5% of GDP), though slower remittances inflows (see Central Europe Economics: Dwindling Remittances, March 20, 2009) and a smaller reversal in income outflows imply that the drop will be less dramatic than in Hungary or Romania, for example. We see the C/A deficit at 3.3% of GDP this year, down from 5.3% in 2008. Importantly, we note that unexplained outflows remain huge, at 4.8% of GDP, which implies much larger financing needs than the current account balance alone suggests. Overall, Polish external balances are in a far less healthy state than commonly believed; however, while the ERM II anchor may prove elusive (see “Central Europe: Trip Notes”, EM Economist, March 6, 2009), an overall better growth track record and lower debt stock as a percentage of GDP (note however the significant deterioration in the budget) place Poland closer to the Czech Republic than to Hungary. Its superior fundamentals were the reason why Poland was recently granted access to the IMF’s Flexible Credit Line for US$20 billion. We believe that this greatly alleviates worries about funding needs in 2009/10 (see “Poland: Risks Abate”, EM Economist, April 17, 2009).

Romania and Bulgaria: Romania and Bulgaria experienced massive capital inflows in the last few years (mostly foreign banks’ credit) as well as significant FDI inflows, especially in the real estate sector. As elsewhere in the region, funding has dried up dramatically, and given how elevated credit growth had been ahead of the crunch, the correction in overall consumption growth and the C/A deficit has already been dramatic, and will continue to be so this year and next, in our view. In Romania, we expect GDP growth to move into deep negative territory in 2009 (-2.6% versus +7.4% in 2008), and the current account gap to narrow sharply to 8% of GDP by end-2009, from a peak of 13.6% reached in the last part of 2008. Bulgaria is experiencing a similarly dramatic correction, with GDP growth likely to turn negative in 2009, after recording an impressive 6% in 2008. The C/A deficit is tracking 22% of GDP (the peak was 26.5% in 4Q08), and the early 2009 numbers suggest that it may narrow to around 15% by year-end. The intensity of the Bulgarian adjustment could feel very severe. Given the strictures of the currency board (money supply is linked to reserves, which could continue to drop in the case of sharp capital outflows), we think that a currency regime change is a possibility late this year or in early 2010, though the government will almost certainly pursue the IMF route before considering abandoning the board.

Baltics and Ukraine: C/A Gaps Evaporate, but Pressure on FX Still Strong

Current accounts are improving in the region but financial accounts are deteriorating. Import collapses are also causing lower budget revenues, turning what was previously a balance-of-payments problem into a fiscal one. The sharp correction in domestic demand is particularly extreme in the Baltic states. February BoP data show current accounts in all countries contracting rapidly, with the trade balance being the main driver. Latvia and Lithuania face the sharpest contraction, both showing positive current account balances already in February. In both, imports are down on average by more than 40%Y and exports down by about 28%Y. In Estonia, the contraction is slower, with imports down 33.7%Y and exports down 25.2%Y. The C/A balance here is still marginally negative, but on a trailing 12-month basis it remains the lowest among the Baltic countries. The relative real appreciation of Baltic exchange rates compared to their trading partners will likely keep the C/A deficits in negative territory for this year, but the gaps should be in the low single-digits (as a share of GDP). Deteriorating confidence from international investors and a credit squeeze have resulted in financial account outflows and some reserve loss across all three economies. While Estonia is in a comparatively stronger position, we now expect eventual devaluation in Latvia, and probably Lithuania (see Baltic Economics: No Longer All for One? April 21, 2009). Estonia and Lithuania lost about 6% of their reserves in 1Q. If not for the €1 billion installment from the EU in February, Latvia would have spent 37% of its reserves in 1Q.

Ukraine: The BoP picture in Ukraine is similar to that of the Baltics, with the current account contracting sharply and financial account turning negative. The C/A recorded a surplus of US$0.5 billion in January due to gas import disruptions and then returned to negative territory. In 1Q exports were down 39.2%Y while imports nearly halved (-46.9%Y), narrowing the current account 4.2 times year on year. We see the C/A gap at just 1% of GDP this year (from 7.5% in 2008). The overall deficit on the financial account is narrowing though. It was US$0.9 billion in March (compared to US$2.2 billion in February), and in 1Q it was 24% lower than in 4Q08 due to the lower cash growth outside the banking system. Private sector debt rollover rates remain strikingly strong in March, 81% in the banking sector and 114% in non-financials. The NBU spent 20% of its foreign reserves in 1Q09, but a likely imminent disbursement from the IMF of around US$5.6 billion leaves the reserve position still relatively comfortable. We expect the UAH to be stable over the next 3-4 months but to weaken again in 3Q.

Turkey: C/A Gap Narrows Quickly, Expected IMF Package Likely to Be Sufficient

In Turkey, the current account balance has turned positive on a monthly basis, for the first time in five years, yielding a surplus of US$0.3 billion each in January and February, bringing down the 12-month rolling deficit to US$33 billion − the lowest print in the past two years. This reversal from a massive deficit to a surplus is the result of the shrinking trade deficit. Exports posted a significant 34%Y decline in February and a mere 9%Y rise on a 12-month trailing basis. However, the slowdown in imports was even more severe due to a sharp drop in commodity (mostly energy) prices, lack of domestic demand for imported goods and especially lower exports that are heavily dependent on semi-finished goods imports: in February, imports declined by a massive 46%Y, pulling down the 12-month rate to 5%Y. On the back of our GDP growth rate forecast revision and tame commodity prices, we lowered our current account deficit forecast from US$17.9 billion to US$9 billion for 2009 (1.4% of GDP), with risks tilted towards an even lower gap.

Financing remains a challenge but is manageable: A combination of the lowest net FDI inflow for over a year (US$0.5 billion), a US$2 billion portfolio investments outflow and a low debt rollover ratio on the part of the corporate sector (i.e., net payer of debt) resulted in a financial account deficit of US$2 billion in February. This figure is a source of concern, especially considering the fact that the private sector debt rollover rate eased to a monthly rate of around 75-80%. While this issue remains one of the top concerns surrounding the external sector, we continue to believe that a significant portion of the corporate sector external borrowing was based on deposit collaterals, and hence the capacity to repay is sufficiently high. That is, we see a lesser degree of systemic risk than the consensus view regarding the prospects of non-financial sector external debt. We note that the net errors and omissions had posted another sizable inflow of US$1.7 billion in February, taking the total figure to a significant US$15 billion between October 2008 and February 2009. The sharp rise in unexplained inflows coincided with the commencement of the weak(er) debt rollover rates seen in the private sector. We believe that these two issues might be closely related and that these funds are most likely under-the-mattress holdings by residents as well as a partial repatriation of funds held at offshore banks.

External financing gap should not be a major challenge, especially with an IMF program: As had been the case back in November 2008, we maintain our view that the overall external financing gap in 2009 could be handled without a major systemic problem. Compared to our previous projections, we now lower the current account gap, which reduces the overall financing need to some extent. On the other hand, we have also revised down our FDI assumptions and, most importantly, assumed a very conservative 50% debt rollover ratio for the private sector. This still yields a gap of some US$10-12 billion, which might mean a loss of reserves and/or currency depreciation. It should be borne in mind that, by nature, we are assuming no FX inflows associated with the net error term, which might turn out to be a strong assumption after all, as the indications so far had been pointing to the opposite (see above discussion). Hence, we maintain our view that an IMF Stand-By Arrangement with a credit facility of some US$20-25 billion would be more than sufficient to ease concerns regarding the financing gap.

South Africa: C/A Deficit to Narrow Marginally in 2009/10

In contrast with the rest of CEEMEA, we expect the C/A deficit in South Africa to narrow only marginally in 2009/10, thanks to relatively inelastic capital import demand (as the government rolls out a number of infrastructure projects ahead of the 2010 FIFA World Cup), and a sharp fall in commodity export revenues. While there may be some import compression as lower oil prices and weaker private consumption and investment spend place a lid on overall import growth, we believe that this is unlikely to fully offset the strong growth in infrastructure-related imports. Also, South Africa is negatively geared to commodity price downturns, given that commodity exports account for as much as three-fifths of exports, but only a fifth of imports. For South Africa’s trade balance to improve during a commodity downturn, commodity import prices (mainly crude oil and petroleum products) need to fall by more than three times the decline in commodity export prices – a rather tall order, in our view.

February improvement in trade deficit a damp squib: It is against this background – among other reasons – that we are inclined to dismiss the sharp improvement in February trade balance from -R17 billion to -R0.6 billion as a one-off blip. First, the sharp improvement comes hard on the heels of a record deficit in January, suggesting that this may be more of a technical rebound than the beginning of a sustained recovery. Second, the reading was largely driven by a much-publicized jump in manufactured and mining exports that was entirely seasonal. With commodities accounting for some three-fifths of exports, it is difficult to see how a continued deterioration in export performance could be averted while global demand remains weak. Third, it is difficult to see a sustainable recovery in manufactured exports (20% of the export basket) when the local manufacturing industry itself is in a historic recession. On the whole, we expect South Africa’s goods and services deficit to widen in 2009/10, and to likely become the dominant driver of the current account deficit – particularly as corporate earnings and dividend payments shrink.

Fickle capital flows a major concern: South Africa’s inordinate reliance on fickle portfolio flows has always been a major drawback – particularly during times of global risk-aversion. Fortunately, a sharp unwind in non-resident portfolio bond and equity positions towards the latter part of 2008 was met by a fortuitous jump in ‘unrecorded transactions’ (a de facto balancing item), and FX repatriations by commercial banks. However, it is important to note that the stock of banking sector FX deposits has already halved from its September 2007 peak of US$26.2 billion. At some point, this cushion may become too thin to matter. One must also remember that capital outflows are not a necessary condition for a high deficit country to face currency pressures: a drying-up in capital inflows alone may suffice. We maintain our bearish view on the ZAR, and recommend going long USD/ZAR at current levels of 9.00 for an eventual move back to 10.00 or higher. Short-term technical and transactional flows (e.g., VODACOM) may present near-term headwinds to this trade.