Most countries in Eastern Europe recorded almost unprecedented economic contraction and market recoveries while celebrating the twenty year anniversary of the fall of the Berlin Wall. It may therefore seem a little far-fetched to argue that Eastern Europe is normalising at the end of one of the most extraordinary years since the transition process started. But there are some notable signs that the region is not only recovering but is about to enter a period of more normal development. The main feature of this new normal is growth in line with potential – rather than over potential – that is not based on low base effect or cheap credit but rather on low inflation, low positive real interest rates and political stability. Most countries in the region are still in recovery mode and will remain so during the first half of 2010, before entering this new normal in the second half of the year. There is, however, a wide spread in the region, and for some of the worst-hit economies in the region, such as the Baltic states, the recovery period will be longer.
Lower but more stable growth
The two biggest economies in the region, Russia and Turkey, are illustrative examples of the normalisation trend. The growth forecasts have been revised up for both economies lately, and the medium-term outlook is good. But growth will most likely stay lower than in the previous cycle. Instead of having growth rates in the range of 6, 7 or even 8% per year, these economies may grow between 4 and 6% per year during the next cycle. The upside is that growth is likely to rest on a more solid ground and therefore be more sustainable. The economies were reformed after the 1998 crisis in Russia and the 2001 crisis in Turkey, which led to a few years of relatively “easy” catchup growth In addition, Russia saw large capital inflows based on extraordinarily high commodity prices and Turkey attracted a lot of capital from carry traders. These drivers are not gone but substantially reduced, but should be replaced by more normal and sustainable drivers.
Low inflation and low positive real interest rates
Turkey and Russia have been plagued by high inflation and abnormal interest rates. In the Turkish case, the rates were among the highest in the world, whereas Russia has had high but negative real interest rates. Both countries have seen inflation come down significantly lately, and the rates have followed suit. There is a lag to more developed markets and we have not yet seen the end of the cycle. Inflation is still falling and rates should be cut a few more times in Russia before the trend is reversed sometime in the first half of 2010. It is therefore quite likely that both countries will have an inflation rate around 5% towards the end of next year, with a policy rate at around 7%.
The past 18 months must have been very stressful for policy makers. Russia and Turkey saw growth collapse and unemployment surge, while their currencies were under a lot of pressure, which could have led to widespread public dissatisfaction. But the AK party in Ankara and the tandem rulers in Moscow have not only remained in power, but have managed to stay quite popular. There is no real alternative to the current regimes in either country and the next elections are a few years down the road. The balance could, of course, be broken by a series of potential domestic or external shocks, but that is rather unlikely and the baseline scenario is that the current leadership stays in power.
These normalisation trends are not only observable in Russia and Turkey. Poland is another obvious example and actually started this trend earlier, as the economy and credit grew more moderately in the previous cycle, and interest rates have been low and positive for quite a few years already. That these countries are normalising from a macro perspective does not mean that they are fully-fledged market economies, but it should send a message to investors that Eastern Europe is moving in the right direction.