S&P: EMEA faster growth, but higher inflation

S&P: EMEA faster growth, but higher inflation
Economies are recovering faster than expected, but that is causing inflation and there is a danger that central banks raise rates too fast that will take the edge off growth. The uneven nature of the recovery could also cause problems.
By Ben Aris in Berlin June 29, 2021

Emerging market economies in Europe, the Middle East and Africa (EMEA) are recovering faster than previously expected from the coronavirus (COVID-19) pandemic, but that has come with higher inflation. With Central Banks across the region starting to tighten monetary policy to curb price rises, that could take the edge off the recovery, international ratings agency Standard & Poor’s (S&P) said in a report released on June 25.

“We have raised our forecasts for GDP growth in 2021 in the key emerging markets of Poland (to 4.5%), Russia (3.7%) and South Africa (4.2%), and we maintain our forecast 6.1% growth for Turkey,” S&P said in its report.

“This surprise upside stems chiefly from stronger-than-expected domestic demand, with consumption proving more resilient to lockdown restrictions this year than in 2020, although consumption and mobility are still highly correlated,” the agency said.

But risks to the recovery remain. The appearance of a delta variety of the virus, which has seen new infections and deaths soar to fresh record highs in countries like Russia in recent weeks is the main risk. Governments are scrambling to contain the outbreaks and Russia has introduced a mandatory vaccination order after more than 20,000 new infections a day – the fourth highest in the world – were reported on June 28.

“Top risks to our forecasts for the region are further infection waves and slower progress in vaccination, delaying the exit from the pandemic, as well as an abrupt tightening in financial conditions linked to uneven global recovery, with US growth powering ahead and the US Federal Reserve potentially raising rates earlier than planned,” S&P said.

Most of the new growth has more to do with strong domestic than recovering exports. As bne IntelliNews reported in a December cover story “Brighter Days Ahead”, the release of a year’s worth of pent up demand has seen consumption soar and lifted all the region’s economic boats at once, which has given the recovery an added impetus.

Consumption in countries that were in lockdowns during part of the first quarter, such as Poland and South Africa, proved to be more resilient to pandemic-related restrictions than S&P anticipated. “Still, the correlation between mobility and consumption remains significant, and third waves in Russia and South Africa pose a risk to the recovery,” the agency said. “Conversely, the significantly improved pandemic picture in Central and Eastern Europe (CEE) bodes well for a stronger recovery in consumption in the coming quarter.”

While the battle against the virus was being won as mass vaccination programmes gathered momentum in the spring, the appearance of mutations has knocked that effort back again in June.

“A faster vaccination pace will be necessary to keep economic activity on track, prevent on-off lockdowns, and ensure a sustainable return to full capacity,” says S&P. “Bringing the pandemic under control is also necessary for the resumption of travel, which is important for the economies in which international tourism contributes meaningfully to growth, employment and foreign currency revenues, such as Turkey.”

Country-specific risks vary and include additional sanctions on Russia, balance-of-payments stress in Turkey, fiscal risks in South Africa, and delays in the implementation of the national recovery plan in Poland.  

Upside growth surprises

GDP rose at a quarterly pace of 1.1% in Poland and South Africa, despite unfavourable pandemic developments and lockdowns during part of the quarter. In Russia, the pace of economic recovery picked up in March, and most indicators point to a strong GDP print in the second quarter.  

Demand has been leading the recovery rather than exports, but as consumption continues that is pulling in more imports and the slower pace of recovery in exports means that countries like Poland and South Africa will start to feel some pressure on their current account balances.  

The situation in Turkey is different, as it was already suffering from an unrelated economic crisis that has seen domestic demand and imports at lower levels to begin with amid some of the highest interest rates in the region and a slower pace of credit growth. In Turkey the largest contribution to growth came from inventories and the decline in imports.

Emerging Europe continues to be ahead of many advanced and other emerging economies in returning to pre-pandemic GDP. Turkey's GDP exceeded its pre-pandemic level already in the third quarter of last year and was almost 7% above that level in the first quarter of this year. Poland’s output was only 1.7% below its pre-pandemic level in Q1, and Russia is also close to its pre-pandemic level of output. South Africa is lagging, with GDP still more than 3% below the pre-pandemic point, but the gap is closing faster than we previously expected.

New lockdowns have a lesser but still meaningful effect on consumption

Overall, the data confirms that new COVID-19 infection waves in 2021 have had a milder impact on domestic economic activity in key emerging markets than the first waves in 2020, reports S&P. Nevertheless, lockdown restrictions on movement are still closely correlated with domestic economic activity.

S&P argues there are three main factors still at play: the pandemic is still restricting mobility in most cases; the consumption gap was much narrower in the first quarter of this year compared to the second quarter of last year when the pandemic began as shopping has moved online; and comparisons between countries show that mobility and consumption are still highly correlated.  

“Overall, we conclude, that changes in mobility affect consumption sizably, even though the impact is more limited than it used to be,” S&P concluded.  

The picture is confused, as the waves of infection are very different in each country. While Russia was seeing over 20,000 new cases on June 29, Ukraine reported only 200 new cases the same day and – so far – has been spared exposure to the new delta variant.  

In Central and Eastern Europe (CEE) and Turkey a third wave has subsided, with new cases looking particularly low in CEE. In Turkey, a third wave took off in March, and accelerated in April, but after a lockdown that lasted around three weeks until mid-May, new daily cases have dropped significantly.

Mobility has improved sharply in CEE and by the end of the second quarter, mobility in Poland exceeded pre-pandemic levels. In Russia, average mobility in the second quarter was still high, which should mean that growth in the second quarter in both countries is much higher, as the mobility will offset the infection spike.  

In South Africa, which introduced regional restrictions, including in the economic hub of Gauteng, the drop in mobility has been more pronounced, but so far measures have been less restrictive, and mobility is holding up better compared to the first and second waves.

Vaccination rollout remains uneven

The appearance of the delta variant has led governments to redouble their efforts to vaccinate the population and get to herd immunity as quickly as possible.  

Vaccine deployment remains uneven in the region, and low overall in many places, reflecting both logistical difficulties related to supply, as well as vaccine hesitancy.  

Poland and Turkey are well ahead (43% and 34% respectively, have received at least one vaccination) while the vaccine rollout in sub-Saharan Africa is very slow.  

In Russia, less than 15% of the population has taken up a vaccine, despite the widespread availability of the domestically produced Sputnik V, as Russians have shown a great deal of mistrust of their government.  

Monetary policy normalisation brought forward

Inflation has also surprised on the upside and that could lead to a fiscal shock for recovery; as bne IntelliNews reported in a DATACRUNCH on policy rate hikes, central banks across the region have started hiking rates to curb price rises as headline and core inflation are running above the target in several emerging markets in EMEA, including Poland, Russia and Turkey.  

“We expected headline year-on-year inflation to increase notably in late Q1 2020 and early Q2 2021, due to base effects from the disinflationary conditions last year, rising energy prices, supply bottlenecks in certain markets, and in some cases a pass-through from weaker currencies. However, inflation in several countries accelerated faster than we anticipated, and price pressures appear broad-based,” S&P said.  

Russia has already raised its policy rate by 125 bps to 5.5% and signalled further hikes. In Turkey, following the hike in March, the central bank has since kept the key rate at 19%. The Polish central bank is likely to raise rates earlier than expected and Czechia and Hungary both raised rates last week.  

By contrast, inflation remains within the target band in South Africa, helped by exchange rate appreciation, although it exceeded the central point of the target in May. 

But inflation may already on the wane. In a surprise move the National Bank of Ukraine (NBU) kept rates on hold in June despite a surge in inflation of 9.5% in May, arguing that food prices will fall in the summer, the high May print was partly due to a low base effect and that the appreciation of the hryvnia was also dis-inflationary.  

“The risk of excessive fiscal tightening has receded, in our view. This year fiscal dynamics have been positive in most key emerging markets in EMEA. The rebound in economic activity has supported tax revenues,” S&P said.  

Turkey’s revenues were up 36% y/y in January-April 2021, a strong rise even accounting for high inflation, driven in part by interest revenues on government cash holdings.  

Russia’s government revenues also increased by more than 20%, driven to a larger extent by a rise in non-oil revenues. The government was expected to run another deficit this year, but by June was already on track for a surplus.  

In South Africa, government revenues started picking up in the fourth quarter of 2020, but over January-April 2021 were only 3% higher than the same period a year ago. The budget deficit has narrowed but remains large at 9% of GDP in the first quarter.  

Spillovers from a stronger global recovery: positive but not without challenges

The strong bounce-back in economies around the world is making life easier for everyone, but the uneven nature of the recoveries – tied to the uneven nature of the availability of vaccines – will also cause problems.  

The main danger is that the US bounces back much faster than everyone else and the US Federal Reserve bank goes back to hiking rates sooner rather than later, which typically sucks money out of emerging markets (EMs) and slows their growth.  

“The US Federal Reserve has recently revised its growth and inflation forecast for the US economy upward, and its dot plot now indicates that the first rate hike in this cycle will be in 2023 (previously 2024), with another to follow in the same year,” says S&P. “As US growth is powering ahead, the risks are rising that the Federal Reserve may start raising rates even earlier. While not our baseline, such a scenario has negative spillovers for emerging markets.”

A higher cost of US dollar-denominated debt will affect countries that borrow or refinance US dollar debt. More generally, widening interest rate and growth differentials between the US and emerging markets could lead to capital outflows from emerging markets, leading to currency depreciation, higher imports costs and financial market volatility at a time when domestic inflation pressures are already significant, says S&P. In turn, this could force central banks into defensive rate hikes, with domestic rates moving fast into restrictive territory.  

“Even in our baseline scenario of “orderly reflation”, some economies in the region might find it more challenging to adjust to higher US yields, especially those with significant external (Turkey) or fiscal (South Africa) imbalances. Generally, in an environment of tighter global liquidity, investors are likely to differentiate more among emerging market economies, with countries making slower progress in vaccination and vulnerable to growth reversal at risk of being exposed to the worsening investors sentiment,” concludes S&P.