East Europe banks may follow Turkey

Bloomberg

Eastern Europe’s key central banks will cut interest rates to record lows this year, opting to counter the deepest recession since the fall of the Warsaw Pact instead of defending weak currencies, Bloomberg surveys show.

Poland’s benchmark rate will fall to 3 percent by year-end from 4 percent, according to forecasts gathered by Bloomberg. The Czech key rate will drop to 1.5 percent from 1.75 percent and Hungary’s will fall to 7 percent, from 9.5 percent. Banks in Poland, Hungary, the Czech Republic and Romania are being forced to tear up monetary policy rulebooks as the worst economic decline since the end of the Warsaw Pact rule engulfs the region. They have to balance between economies buckling under the weight of the crisis and currencies plunging as investors flee emerging markets.

"You’ve got to ask yourself in the current climate whether or not the conventional response of hiking interest rates is going to achieve anything," said Neil Shearing, an economist at Capital Economics in London. "Interest rates are not what’s driving currencies at the moment. It’s all about fear and panic. They can’t afford not to cut rates at this stage."

Regional central bankers met in Budapest Friday to discuss "matters of mutual interest." Czech, Hungarian and Polish monetary policy makers will make rate decisions next week, with Romania following on March 31.

Currency woes

The region’s currencies are among the worst performers in the past six months. Of 26 emerging-market currencies tracked by Bloomberg, the Polish zloty has tumbled the most, losing 28 percent against the euro. In third place is the Hungarian forint, which has dropped 20 percent. The Romanian leu has weakened 16 percent and the Czech koruna 11 percent.

While declining currencies make policy makers unable to match the scale of easing at central banks such as the Federal Reserve or the Bank of Japan, eastern European rates are set drop through this year, Bloomberg’s surveys of economists and strategists show. Polish rates may fall as soon as next week, while Hungarian and Czech borrowing costs will probably remain unchanged this month, according to the surveys.

Rate reductions loom as the deepening global crisis cripples the region’s economies, forcing plant closures and driving up unemployment. Falling tax revenue threatens to inflate budget deficits and may throw euro-adoption plans off-track.

"The economic outlook is supportive of a pretty aggressive easing story," said Michal Dybula, a Warsaw-based emerging Europe economist at BNP Paribas. "Policy makers in central and eastern Europe need to reassess the business cycles for these economies. They are way behind the curve in the sense of how bad the real economies are."

Collapse in export demand

The region faces a recession this year as export demand collapses, the International Monetary Fund said in January, forecasting a 0.4 percent contraction. Companies from the local units of General Electric and KBC Groep to Telekomunikacja Polska are curtailing production or cutting jobs.

The IMF, which has bailed out Latvia, Hungary, Serbia, Ukraine and Belarus, and is in talks with Romania, warned on Jan. 28 that bank losses may widen as "shocks are transmitted between mature and emerging-market banking systems."

In the short term, the region’s policy makers will proceed gradually, with an eye on the currency markets, economists said. Of the four central banks due to set rates before the end of the month, only Poland is predicted to lower its rate, by a quarter percentage point, to 3.75 percent, 11 economists forecast unanimously.

"Should the exchange-rate weakness become sustained, it would endanger reaching the inflation target," the Magyar Nemzeti Bank said in a statement on March 8, a day after the forint fell to a record low against the euro. Hungary’s central bank will leave its rate unchanged at 9.5 percent and its Czech and Romanian counterparts will hold them at 1.75 percent and 10 percent respectively, the surveys show.

The Czech central bank’s mid-point inflation target is 3 percent this year and 2 percent next year. The annual rate was 2 percent in February. In Hungary, the rate fell to 3 percent for the same month, meeting the policy makers’ target for the first time in almost three years.

Poland’s annual inflation rate was 3.3 percent last month, having returned to the central bank’s target range of between 1.5 percent and 3.5 percent in December after exceeding it for a year.

Raising rates is no longer an efficient way of fighting currency weakness, economists said. Currencies are "an obstacle in the short term because if they cut rates they can aggravate the sell-off and they also need to consider volatility and the psychology of markets," said Zsolt Papp, an economist at KBC Groep in London. "In the longer term, they have no other choice but to cut rates. If they can’t bring rates down to acceptable levels, recessions may last longer."