Eastern Europe Slows Rate Increases as Russia Signals Concern on Recovery

February 1, 2011



Central banks in eastern Europe, the region hardest hit by the global financial crisis, will raise interest rates less than other emerging markets as policy makers signal greater concern about growth, economists said.

Emerging Europe’s economies will expand 3.6 percent this year, compared with 8.4 percent predicted for Asia’s developing economies and 4.3 percent for Latin America, according to International Monetary Fund’s January forecasts. Russia yesterday unexpectedly kept its deposit rate unchanged, while money market rates for Poland and Hungary show that investors have scaled back bets on how far borrowing costs will rise.

Global rate setters are growing more concerned that inflation is accelerating as the world economy gathers strength and food and oil prices rise. While Hungary, Serbia and Poland have raised borrowing costs, emerging Europe’s rates will rise more slowly than in Asia and Latin America, which are growing twice as fast, according to Commerzbank AG, Capital Economics Ltd. and Bank of America Merrill Lynch.

“With the still sluggish growth rate, east European central banks can’t afford to be very aggressive,” said Michael Ganske, head of emerging-markets research in London at Commerzbank, Germany’s second-biggest lender. “You can’t purely look at inflation when you’re just coming out of a major economic crisis.”

Russian Rates

In Russia, where President Dmitry Medvedev set an annual growth target of 8 percent to 10 percent in five years, the central bank opted to raise reserve requirements for banks to contain inflation without throttling the recovery. It surprised 12 of 16 economists in a Bloomberg survey by keeping the deposit rate unchanged.

Bank Rossii kept all interest rates on hold, including the key refinancing rate at a record-low 7.75 percent. The IMF expects Russia to grow 4.5 percent this year, compared with 9.6 percent for China and 8.6 percent for India.

Forward-rate agreements used to lock in interest costs in a year’s time now indicate Polish rates will increase by 1.08 percentage points by year-end; two weeks ago they predicted 1.25 percent.

Hungarian contracts now show the bank may be done raising rates, compared with rate bets of 52 basis points two weeks ago. Contracts for the Czech Republic, where the bank has kept rates at a record low 0.75 percent since May, signal an increase of 85 basis points, compared with 82 two weeks ago.

India, Brazil

In India, where the central bank last week resumed rate increases, bets on the extent of tightening are rising. The cost of one-year interest-rate swaps used to guard against fluctuations in borrowing costs rose 29 basis points this month to 7.43 percent. Brazil’s central bank last month lifted rates 50 basis points and signaled it will move again in March. Yields on interest-rate futures contracts due January 2013 have risen 52 basis points in the past month.

Interest-rate derivatives markets may still be overestimating increases to east Europe’s policy rates because central bankers may be unable to influence food and energy-related price gains with monetary tightening, said Neil Shearing, senior emerging markets economist at London-based Capital Economics.

Central banks may tolerate some inflation “because they know where it’s coming from, food and energy prices, and they know that they don’t have much control over that,” he said. “In much of the region there are still major growth challenges.”

Inflation Threat

The share of food prices in consumer-price baskets across the region is between 20 percent and 40 percent, BNP Paribas SA economist Michal Dybula said. Inflation is a threat to eastern Europe’s recovery as it may damp consumer spending and prompt interest rate increases, the European Bank for Reconstruction and Development said last week.

Because of sluggish economic growth, the dilemma for emerging European central bankers is more similar to that of U.S. and western European policy makers than the challenges faced by their Chinese, Brazilian or Indian counterparts, Commerzbank’s Ganske said.

The Federal Reserve last week maintained plans to buy $600 billion of Treasuries through June to help reduce unemployment. European Central Bank President Jean-Claude Trichet said on Jan. 26 in Davos, Switzerland that euro-region interest rates were “appropriate.”

Most Hawkish’

Serbia’s central bank, which Timothy Ash, head of emerging-market strategy at Royal Bank of Scotland called Europe’s “most hawkish,” led rate increases, lifting borrowing costs times since August by 4 percentage points to 12 percent as losses in the currency fueled inflation.

Hungarian policy makers last month raised the country’s benchmark rate a quarter-point to 6 percent, the third consecutive increase. The central bank sought to tighten policy before Prime Minister Viktor Orban appoints board members more likely to favor lower rates, RBC Capital, Citigroup Inc. and Capital Economics said.

Poland followed on Jan. 19 by raising rates a quarter-point to 3.75 percent from a record low to tame inflation expectations and strengthen the zloty. The Czech central bank has signaled it may raise its main rate in the second half.

Following the rate moves, policy makers toned down their inflation-fighting rhetoric.

On a Hair’

Hungarian central bank President Andras Simor said after the Jan. 24 meeting that the vote to raise rates hinged “on a hair” and that council members were “very open” about next month’s decision. Polish central bank policy maker Andrzej Bratkowski, who had in the past favored higher rates, said on Jan. 25 that the next rate increase may only come in May or June rather than March.

Polish, Hungarian and Czech inflation rates will breach the upper limits of monetary policy makers’ targets this year, according to the central banks. Bank Rossii’s 6 percent to 7 percent goal this year will be “very difficult” to meet, the bank’s First Deputy Chairman Alexei Ulyukayev said on Jan. 20.

“Inflation risk is real, forcing most central banks to react,” said Raffaella Tenconi, a London-based economist at Bank of America Merrill Lynch. “The recovery in domestic spending is nascent, implying the required monetary tightening in the near term remains contained.”

The spread between the yield on Poland’s inflation-linked bonds due in August 2023 and similar maturity government debt was at 3.35 percentage points today. The difference, known as the breakeven rate that reflects investors’ expectations for consumer-price increases, has risen 28 basis points this year.