EM Thematic: CEE Central Banks to React Slowly to a German Recession

Summary

• Germany’s economy is slowing rapidly, leaving spillover risks for central Europe.
• Czechia’s concentrated product mix, reliance on traditional industries and high openness leave it particularly vulnerable.
• Hungary’s high export share and weak domestic demand also leave its economy exposed.
• Poland should remain fairly insulated from a German recession via a more diversified product base, less open economy and loose fiscal policy.

Market Implications

• Accelerated ECB easing is unlikely to bring faster rate cuts in CEE as inflation, rather than growth, remains the main component of CB reaction functions.
• But weaker exports and growth will weigh on CZK and HUF, cementing our already bearish view.
• NEW TRADE: We go long PLN/CZK, targeting 6.05 in three months.

Mounting German Weakness

Domestic demand in CEE remains soft, and the external environment is increasingly weak. Debate over German deindustrialisation has intensified as survey data drop to lows last seen during the GFC/pandemic. Already-cautious CEE households are building up savings. And with limited fiscal space, downside risks to growth are mounting. We review what has changed and what it means for policy in CEE.

Chart 1: blue line = IFO business situation, orange line = expectations (6m ahead). Chart 2: blue bars = GDP growth forecasts from March 2024m orange bars = June 2024, grey bars = September 2024.

Uneven Spillover in CEE

Expectations that the German economy will tip back into recession have been circling for months. Meanwhile, structural constraints on demographics and underinvestment into the green transition and digitization are long-standing concerns. But the planned closure of several Volkswagen plants and announced job cuts at other major companies have highlighted the depth of Germany’s problems.

Whether Germany faces deindustrialization – triggered partly by loss of access to cheap Russian gas alongside competition from China – or, as the IMF argue, aging, underinvestment (in part due to fiscal conservatism) and red tape, matters for how German policymakers approach the problem. But for policymakers in central Europe, the spillovers remain the same: weakness in exports and IP, sentiment and investment.

Chart 3: blue line = Poland IP (index), orange line = Czechia, grey line = Hungary, black line = Germany. Chart 3: blue bars = export share to Germany, orange bars = other CEE, grey bars = France, white bars = Italy, orange shaded bars = Netherlands, black bars = US.

Czechia sends a larger share of its exports to Germany than Poland or Hungary. But Poland’s 28% share remains significant – and higher than Hungary’s. Yet Polish industry has outperformed (Charts 3 and 4). We see four main reasons.

1) Export composition. CNB analysis highlights that while the market share of Czech exporters to Germany has broadly declined in recent years, Poland has achieved a rising market share, barring the 2022 Russia-Ukraine related dip (Chart 5). A different composition of exports is the key reason, with Czechia’s increasingly concentrated in machinery (and parts), autos and metals (Chart 6). We find a similar picture in Hungary where, despite the shift to EVs, exporters have yet to see a material shift in market share.

This reliance on Czech exports of intermediate products leaves a strong, fast passthrough to exports from German demand. The high share of products for specific customers with no alternative end customer is another vulnerability.

Poland, by contrast, has diversified its exports to Germany, shifting from reliance on furniture to exports that now compete with those from Czechia (Chart 7). And while Poland lags Hungary’s big-ticket EV investment/manufacturing, Poland is nevertheless an increasingly important battery producer.

Chart 5: blue line = Czechia, share in German imports (%), orange line = Poland. Chart 6: blue bars = Czechia market share of electrical machinery to Germany (% weighted by share in exports), orange bars = vehicles, grey bars = machinery, white bars = furniture, black bars = iron / steel, blue shaded bars = plastics, orange shaded bars = other. Chart 7 = . Polish market share of the same components.

2) Openness. Poland’s larger and more domestically focused economy reduces its overall reliance on trading partners compared to Czechia. Versus Poland’s 60% share of exports in GDP, Czechia’s exports are a larger 74%, and Hungary’s are at 84% (Romania is a lower 40%). As a result, Polish IP, via the domestically focused components such as food production, correlates less with external demand.

3) Fiscal. Poland’s looser fiscal stance has supported stronger domestic demand and sentiment, partly through public sector and minimum wage increases. While this does not impact exporters directly, looser fiscal policy and higher wage growth will again mean a lower growth beta to Germany.

Czechia is running a tight fiscal policy with a 2% GDP fiscal consolidation package in place. Meanwhile, in Hungary, the fiscal impulse is also negative given the large deficit following the 2022 election.

4) Price competitiveness. CNB Governor Michl’s strong currency policy may be one of several drivers of Czech export under-performance. The koruna is around 9% stronger versus EUR over the past 10 years, and 26% over 20 years. PLN is broadly flat in nominal terms over the same time periods, while HUF is substantially weaker (Chart 8).

Lower inflation since January and modest currency weakness has reversed some of the rapid real appreciation of 2020-2023. But that followed several earlier periods of sharp real appreciation, leaving CZK with a more significant loss in competitiveness over the past 10 and 20 years than PLN and HUF (Chart 9).

Chart 8: blue bars = change versus EUR over past 10 years, orange bars = last 20 years.. Chart 9: blue line = Czechia REER, orange line = Poland, grey line = Hungary.

Real appreciation of PLN has also been quick since 2023. However, EUR/PLN has remained above exporter profitability thresholds, and nominal appreciation was a consensus view following last year’s change of government and release of EU funding (Chart 10).

By contrast, investor positioning on CZK has generally been bearish. And while the currency has weakened YTD, the move has been modest versus our expectations.

Chart 10: blue line = profitability threshold for Polish exporters, orange line = EUR/PLN.

Limited Correlation With ECB Policy Moves

Fed/ECB actions influence policy decisions in CEE, but mostly indirectly via sentiment and FX strength. NBP Governor Glapinski said explicitly at last week’s press conference that ECB cuts would not impact the pace of easing in Poland.

With common inflation targets at the CNB and ECB (unlike slightly higher targets at the NBP or NBH), the CNB could be expected to follow the ECB. Correlation with ECB policy rates was higher in Czechia pre-2018. But once the pandemic-related disruption hit, the CNB cut faster – albeit from a higher starting point. And again, once inflation accelerated in 2021, the CNB hiked earlier and faster than the ECB. The current easing cycle has also preceded the ECB.

Overall, the CNB’s previous practice of following the ECB with a 2-3 month lag no longer holds.

Chart 11: blue line: change in NBP policy rate (pp), orange line = CNB, black line = ECB.

Remaining Firmly Bearish CZK and HUF

We have been bearish CZK and HUF. For CZK, reasons included continued rate cuts, weak growth, declining wage expectations and contained core inflation. For HUF, we cited rising macro vulnerabilities with potential fiscal loosening and the high likelihood of a pro-growth NBH governor next year. Exposure to a German recession reinforces these bearish views.

Czechia’s stagnant market share in Germany, concentrated product mix and loss of competitiveness through faster real and nominal appreciation leaves the economy, and currency, particularly exposed. Hungary’s large export share in GDP, weak domestic demand and limited improvement in market share despite the EV investments also leave it exposed.

However, for Poland, PLN weaker than the exporter profitability threshold, a more diversified product mix, a rising share in German imports and stronger domestic demand leave the zloty more insulated.

The Trade

We initiate a long PLN/CZK position at current levels (5.87 spot ref). We target 6.05 with a stop of 5.79.

Caroline Grady is Head of Emerging Markets Research at Macro Hive. Formerly, she was a Senior EM Economist at Deutsche Bank and a Leader Writer at the Financial Times.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)