ECONOMIC RESEARCH •

ENGLISH EDITION MARCH 2007

Eastern European Outlook

Theme: Overheated in the Baltics

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SEB Economic Research
Eastern European Outlook - March 2007

Eastern European Outlook is produced twice a year. This report was published on March 21, 2007.
It was written by Mikael Johansson (Chief Editor), Bo Enegren, Alge Budryte, Gitanas Nauseda, Hardo Pajula, Vilija
Tauraite and Andris Vilks.
Klas Eklund, Chief Economist +46 8 763 8088
klas.eklund@seb.se
Håkan Frisén, Head of Economic Research 8067
hakan.frisen@seb.se
Bo Enegren, Economist 8594
bo.enegren@seb.se
Ann Enshagen Lavebrink, Research Assistant 8077
ann.lavebrink@seb.se
Mikael Johansson, Economist 8093
mikael.johansson@seb.se
Tomas Lindström, Economist 8297
tomas.z.lindstrom@seb.se
Fax no. +46 8 763 9300

SEB, Economic Research, K A3, SE-106 40 STOCKHOLM

Alge Budryte, Economist +370 5 268 2508

SEB Vilnius Bankas
alge.budryte@seb.lt
Gitanas Nauseda, Chief Economist +370 5 268 2517
SEB Vilnius Bankas
gitanas.nauseda@seb.lt
Hardo Pajula, Chief Economist +372 665 5173
SEB Eesti Ühispank
hardo.pajula@seb.ee
Vilija Tauraite, Economist +370 5 268 2521
SEB Vilnius Bankas
vilija.tauraite@seb.lt
Andris Vilks, Chief Economist +371 721 5597
SEB Latvijas Unibanka
andris.vilks@seb.lv

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2
 Summary
Eastern European Outlook — March 2007

Central and Eastern Europe will remain economically strong in 2007-2008. Latvia, Estonia and
Slovakia will grow the fastest. Growth in the region will be cooled off to some extent by higher
interest rates, somewhat lower international demand and increasing supply side restrictions. Rapid
pay hikes that stimulate private consumption are a driving force throughout these countries. EU
members in the region also receive sizeable sums from the EU structural funds, which will help
ensure continued strong investments, especially in Poland.
Meanwhile the Baltic countries and Central Europe will be plagued by continued large internal
and/or external imbalances, which pose risks of economic and financial instability down the road.
No vigorous action in the form of fiscal austerity programmes is on the horizon yet. One exception
is Hungary, whose imbalances have been the most accentuated and where budget tightening will
continue at the price of a major growth slump and, in the short term, high inflation. Latvia’s auster-
ity package, which was recently unveiled, is not sufficient to bring down the country’s high inflation
and ballooning current account deficit more than marginally.
The imbalances will affect the euro adoption timetable. In Central Europe, budget deficit are
admittedly shrinking. But in 2008, the deficits in Poland, Hungary and the Czech Republic will still
be above the threshold to qualify for euro adoption, 3 per cent of GDP. Slovakia may adopt the
euro in 2009, but it will take several more years for the other EU countries in the region — includ-
ing the Baltics, where budgets are balanced but inflation is too high to join the euro zone.
The theme article in this issue deals with overheating in the Baltics. Latvia and Estonia contin-
ue to exhibit clear signs of overheating after several years of excessively fast, domestically driven
growth. Our main scenario is a soft landing for these economies. But this presupposes a continued
slowing of high credit growth. Commercial banks must be more restrictive about lending. Fiscal
tightening may also be required in Estonia to avoid a hard landing that might include currency
devaluations.
Russia’s economy will continue growing at a healthy pace, fuelled by domestic demand. Expan-
sive fiscal policy ahead of the Duma and presidential elections, combined with high commodity
prices, will support such growth. Investments have taken off, but the level remains relatively low
from the perspective of long-term growth requirements. Russia faces a variety of challenges due
to capacity constraints in the energy sector, real appreciation of the rouble, unfavourable demo-
graphics and increased labour shortages. Meanwhile Russia’s expected World Trade Organisation
membership in 2008 will pave the way for better growth.
In the past year, Ukraine has returned to its growth track. GDP is increasing relatively fast.
Driving forces include domestic and partly credit-driven demand, as well as favourable global
commodity markets. In recent months, political worries have re-emerged. Speculation about a
currency devaluation may surface once again.

3
 The international economy
Eastern European Outlook — March 2007

Robust growth In Europe, the Nordic countries will stand out due to
continued high growth, with mounting risks of
overheating in Denmark and Norway. Sweden and
„ Mild deceleration in the US
Finland will grow by an average of more than 3 per
„ Europe and Asia resisting US slowdown well cent annually, accompanied by a mild upturn in
„ Weaker dollar inflation during 2008.
The euro zone will continue to enjoy good growth,
Global economic growth will remain brisk in the next combined with subdued inflation; GDP will increase
couple of years, even though US growth has down- by 2½ per cent annually and inflation will be in line
shifted to moderate speed. Dynamic domestic demand with the European Central Bank’s target of just below
in Western Europe and rapid growth in Asia will fuel 2 per cent. The German economy woke up vigorously
expansion. The world economy will also continue to last year, and both business and household sentiment
be driven by powerful long-term supply side forces. indicators point towards a continued favourable trend.
Tough competition and rapid productivity increases The labour market will keep on improving throughout
will slow inflation. Energy prices will probably level the euro zone. Even in Germany, households are
off as well. This means that both central bank tighten- expected to be more optimistic — or less pessimistic
ing and a market-governed upturn in long-term bond — about opening up their wallets, while the capital
yields will be modest. World economic expansion can spending upturn will continue. The driving forces of
thus remain well above its 3½-4 per cent trend level. growth will shift successively from exports to domes-
tic demand. Fiscal policy will tighten in many coun-
GDP growth tries, especially in Germany. Combined with good
Year-on-year percentage change growth, this will cause government budget deficits to
shrink.
2005 2006 2007 2008
United States 3.2 3.3 2.4 2.7
Japan 1.9 2.2 2.0 2.0 European interest rates upward
China 9.9 10.5 10.0 9.5 The Fed has stopped raising its key interest rate, while
Euro zone 1.5 2.8 2.5 2.3 central banks in Western Europe will continue to hike
Nordic countries 2.9 3.9 3.2 2.5 theirs. This will occur largely for preventive purposes.
OECD 2.6 3.2 2.7 2.7 Long-term inflation risks stemming from tighter
World 4.9 5.2 4.7 4.7 labour markets and rapid lending growth will weigh
Sources: OECD, SEB heavier than today’s low inflation. Several central
banks, among them the Bank of England and the Bank
The risk of a deep US downturn has diminished in the of Japan, have also explicitly warned against exces-
past six months. The response of households to sive risk-taking in financial markets. The BoE will
falling home prices, in the form of increased saving raise its key rate a notch this spring, while the ECB
and lower consumption, appears to be mild. Further- will hike its refi rate by a total of 50 basis points
more, it will take a bit more time before the labour during the next six months to 4.25 per cent.
market begins to weaken. Our main thesis is still that
Bond yields will climb a bit higher, after sinking at the
the US will undergo a soft landing after a lengthy
time of the February stock market slide. They will rise
period of relatively high growth, including some
somewhat more in Western Europe than in the US,
worrisome inflationary impulses last year via the tight
due to economic strength and higher key rates.
labour market. During the fourth quarter of 2006, the
economy grew at an annualised rate of just above 2 Interest rate spreads have been an important force in
per cent. Earlier interest rate upturns, continued to the foreign exchange market in recent years and will
cool the construction and real estate markets. In continue to play a key role. The dollar will weaken as
addition, the business sector began to draw down US-European rate spreads shrink. At the end of 2007,
inventories, a process expected to persist for a couple a euro will be worth USD 1.35. The dollar will stop
of quarters and to help keep GDP growth down. falling during 2008 as the American economy begins
Meanwhile there are various expansionary forces. to accelerate again.
Companies are well-consolidated, which promises a
continued capital spending upturn. The dollar is We assume that oil prices (Brent) will be at USD 62/
expected to weaken, which will benefit exports. And barrel during the next couple of years.
late this year, we anticipate that the Fed will carry out
the first of two interest rate cuts. Overall GDP growth
will be around 2½ per cent annually in 2007-2008.
This is somewhat below the potential level of around
3 per cent.

4

Macroeconomic strength,
structural question marks
„ Continued consumption boom
„ Large but shrinking budget and current ac-
count surpluses
„ No change of course after presidential election
The Russian economy continues to grow at a healthy
pace. In 2006, GDP rose by 6.7 per cent, or just
above the average for the past five years. Growth will
cool only moderately in the next couple of years to
6.5 per cent in 2007 and 6.0 per cent in 2008. Growth
is driven, above all, by robust private consumption but
investments — including foreign direct investments
— have recently gained momentum.
Exports continue to increase at a slow pace, mainly
due to capacity constraints and insufficient invest-
ments in the oil and gas sector. The net contribution
from foreign trade thus remains sharply negative,
since import volume is increasing several times more
than export volume due to strong domestic demand,
eagerness to import and weakened competitiveness in
the wake of real-term rouble appreciation. Yet foreign
trade still provides large but diminishing surpluses,
thanks to a favourable price trend for Russia’s com-
modities-heavy exports.
Russia: GDP and inflation
Year-on-year percentage change
10
GDP (LHS)
Inflation (RHS)
8 20
6 15
4 10
2 5
0
2000 2001 2002 2003 2004 2005 2006
Sources: Federal State Statistics Service, SEB
Due to continued rapid real wage increases, a stronger
labour market and fiscal stimuli, consumption will
remain the most important growth force over the next
two years. The appetite of households for credits has
also risen sharply, including a rapid increase in resi-
dential mortgage lending. This is fuelling consumption
even more. The investment outlook appears more
uncertain, but public spending on infrastructure and
expansion in domestically oriented sectors are signs
that investments will also increase at a healthy pace
during the next couple of years. The level of invest-
ments will remain relatively low, however, and it is
uncertain to what extent public investments will be
Russia
Eastern European Outlook — March 2007
capable of boosting the growth potential of the
economy. The challenge is still to elevate the level of
private investments, and there are a number of
lingering question marks concerning the general
investment climate. Corruption, unclear rules of the
game and ever-increasing public sector intervention in
the business sector must be weighed against rapid
growth, strong federal finances and low external
indebtedness.
Last year the surplus in the federal government budget
amounted to 7 per cent of GDP, largely unchanged
from the year before, despite major increases in
expenditures. The explanation is continued large oil-
related revenue. Given lower average oil prices and
continued increases in expenditures, the budget
surplus will shrink this year to around 4 per cent of
GDP. The current account surplus has also culminat-
ed, but during the next two years we expect contin-
ued sizeable surpluses.
Inflation has trended downward in the past six years.
Last year it fell below 10 per cent. The Bank of
Russia’s primary means of slowing inflation is to
allow a certain nominal appreciation of the rouble.
Last year this amounted to nearly 4 per cent in relation
to a basket consisting of 60 per cent US dollars and
40 per cent euros. In February, the composition of the
basket was changed to 45 per cent euros and 55 per
cent dollars. We expect the rouble to strengthen
somewhat further in the next couple of years, which
will help keep inflationary pressure down. Among
offsetting factors will be continued fiscal expansive-
ness, gradually higher energy prices and a tighter
25
labour market. Overall, we foresee a continued
SEB
forecast downtrend in inflation, but at a somewhat slower
pace. Last summer’s decision to make the rouble
convertible will eventually open the way to a more
developed capital market. This in turn will make it
easier for the central bank to pursue a more traditional
interest rate-determined monetary policy. Central bank
representatives have also hinted that they may switch
to a clearer inflation target within five years.
2007 2008
0 Challenges further ahead
While short-term growth prospects look bright, not
least because the large public financial surpluses are
now increasingly being spent, it will be more difficult
to sustain high growth in the medium term. During
the first half of the present decade, the Russian
economy benefited from a number of factors that are
now fading away.
„ The sharp weakening of the rouble after the 1998
financial crisis gave Russian industry a substantial
competitive advantage. Since then, the real effec-
tive exchange rate has been climbing and has even
passed its pre-1998 level. Although it is unclear
whether the rouble is over-valued today, Russia’s
competitiveness has undeniably weakened, as has
5
 Russia
Eastern European Outlook — March 2007
also been evident from sharply negative contribu-
tions from foreign trade since 2004. Due to the
phase-out of highly subsidised energy prices,
another competitive advantage will gradually fade.
„ In the first post-crisis years, production rose
sharply without any major investments because
capacity utilisation was initially so low. This “easy”
way of boosting production is hardly available any
longer, since a large proportion of capacity has
been mobilised. Labour market resources are also
becoming scarcer. Unemployment has fallen
significantly, while the working-age population is
now beginning to fall.
„ During the early years of the decade, growth was
largely driven by rising production and exports in
the oil and commodities industry. When production
decelerated in 2004, among other things due to
insufficient investments, the commodities sector
continued to fuel growth, thanks to sharply rising
prices for oil and other commodities. Large oil
income will continue to fuel economic growth in
the short term, especially as fiscal policy becomes
more expansive, but given our forecast of an oil
price stabilisation at current levels, the stimulative
effects will slowly diminish.
Russia: Real effective exchange rate
Index
180 180
170 170
160 160
150 150
140 140
130 130
120 120
110 110
100 100
90 90
80 80
97 98 99 00 01 02 03 04 05 06
Source: J.P. Morgan
Speeding up investments and bringing about a diversi-
fication of the economy are regarded by the political
leadership as high-priority economic policy tasks. To
date, there has also been a diversification of the
economy in the sense that resources have been
transferred from the commodities sector to such
domestic sectors as the distributive trades and con-
struction. The Russian labour force seems to be
relatively mobile between sectors, whereas geographic
mobility is substantially more sluggish. This is also
leading to major labour shortages in some expansive
areas, for example the St. Petersburg region. Looking
at the composition of exports, however, we cannot
say there has been any diversification away from
dependence on commodities. On the other hand, the
dependence on commodities does not appear to have
greatly increased either. Russian industry outside of
the energy sector and other industries with a low level
6
of value-added, such as steel and chemicals, are and
will remain a small part of the economy during the
foreseeable future.
Russia: Production and oil price
70 14
13
12
60
11
10
50
9
USD/Barrel
8
Per cent
40 7
6
30 5
4
3
20
2
1
10 0
01 02 03 04 05 06
Oil production (RHS) Oil price, Ural, (LHS)
Sources: Federal State Statistics service, Reuters EcoWin
The government’s policy for stimulating investments
includes the launching of a federal investment fund, as
well as the establishment of economic zones. The
investment fund, created in 2006, is aimed at financ-
ing collaboration between the public sector and private
market players in order to stimulate innovation and
diversification in the economy. The money available to
the fund is relatively modest, about 0.3 per cent of
GDP in 2007. The importance of the fund will instead
depend on whether it is able to serve as a model for
how to select and implement investment projects in an
efficient, transparent way, rather than on the actual
size of its investments. The new economic zones are
intended to serve as innovation centres and will enjoy
special tax advantages. Worth mentioning in addition
to these initiatives for raising the level of investments
are Russia’s high-priority “national projects”, includ-
ing housing construction investments.
While the Russian Federation government is trying to
encourage investments in this way, its own burgeon-
ing involvement in the energy sector in particular is
hampering investments. High taxation in the energy
sector has probably also helped inhibit investment
activity. Discussions are under way on changes in tax
rules to increase incentives for exploiting new oil and
gas resources. For some time there have also been
plans to enact a law that will define what sectors are
regarded as strategic, which in itself would dispel
some of the uncertainties related to investment
decisions. Possible Russian WTO membership also
implies making the rule system governing foreign
investments clearer (see box). Regardless of the
government’s intentions, extensive bureaucracy and
corruption remain serious obstacles to a more favour-
able Russian investment climate.
While Russia is showing structural weaknesses, its
macroeconomic development has been impressive in
recent years. Both the budget and the current account
have generated huge surpluses, which have enabled

Russia to pay off major portions of its foreign debt,
sharply increase its foreign exchange reserve and
allocate funds to the national oil Stabilisation Fund,
which has grown in only a few years from nothing to
the equivalent of 10 per cent of GDP. Although fiscal
policy has become substantially more expansive in the
past two years, there has still been significant resist-
ance to spending Russia’s large oil income. This
means that the country is well prepared for any
downturn in oil prices. Oil prices would also have to
fall below USD 40/barrel (Ural) for the budget to
show a deficit, i.e. far lower than our own assump-
tions of an average oil price of around USD 59/barrel.
The Stabilisation Fund now serves partly as a buffer
against oil price fluctuations and partly as a way of
countering upward pressure on the rouble by invest-
ing oil income in foreign financial assets. According to
OECD estimates, about 3/5 of increased oil revenue in
2004-2005 was neutralised by allocations to the
Stabilisation Fund and advance payments of loan
principal. Oil revenue in excess of USD 27/barrel
(Ural) goes directly into the oil fund or towards
paying off federal government debt.
Russia elects the lower house of the federal Parlia-
ment (or Duma) in December 2007 and a new presi-
dent in March 2008. There is no doubt as to which
election is attracting greater interest. During Vladimir
Putin’s years as president, more and more power has
been concentrated in the Kremlin at the expense of the
Duma. The Duma election is also highly predictable,
since there are hardly any clear anti-Kremlin opposi-
tion forces except for the Communist Party and the
Russia on its way into the WTO
One of the last obstacles to Russian membership of
the World Trade Organisation was removed in
November 2006 when a bilateral protocol was signed
with the US. In January the final remaining bilateral
negotiations with El Salvador and Costa Rica were
concluded. What remains is multilateral negotiations
in which the final terms of membership will be
decided. These negotiations will proceed this spring
and at best be completed during the summer. In that
case, a WTO agreement could go into effect in
January 2008.
However, there is a risk that obstacles will emerge
along the way. One might be Russian plans to raise
its export duties on timber. The purpose from Rus-
sia’s perspective is to increase the low degree of
value-added in its forest product industry. The first
hike is scheduled for July 2007, followed by a number
of additional hikes. This would adversely affect the
Nordic forest product industry, especially in Finland,
where timber supplies would become substantially
more expensive.
If it joins the WTO, Russia undertakes to lower its
tariffs on industrial and agricultural products by 3
7
Russia
Eastern European Outlook — March 2007
small liberal parties. The room for surprises has also
diminished, among other things due to certain consti-
tutional changes, such as raising the threshold for
getting into the Duma from 5 to 7 per cent. Mean-
while independent candidates may no longer be
elected.
Instead the excitement about President Putin’s suc-
cessor is growing. There is still speculation that Putin
might defy the constitution and remain in office for a
third term, but time seems to be running out for such
a solution. Most likely, one of the main candidates —
Dmitry Medvedev, deputy prime minister and chair-
man of Gazprom, or Sergei Ivanov, defence minister
and recently also promoted to deputy prime minister
— will succeed Putin. Of the two candidates,
Medvedev currently enjoys greater popular support.
He is also generally regarded as a more liberal-minded
candidate than Ivanov, which on the other hand may
put him at a disadvantage among more hard-line
circles in the Kremlin.
The blessings of Putin are generally regarded as
indispensable to the successful candidate. This
probably also means there will be little political change
after a new president takes over, at least in the short
term. We expect the direction of government policies
to remain largely in place. It is also entirely conceiva-
ble that Putin will launch a relatively unknown candi-
date for the presidency. As for Putin’s own future
role, it is hardly likely that at age 55 he will be content
with the role of pensioner. Instead, he is likely to
continue to play a key role in Russian public life, for
example via a top position at Gazprom.
percentage points to 11 per cent on average. For a
number of industrial commodities, the reduction will
be much larger than this. However, this will occur
gradually over several years. The direct effects of
these cuts will probably be relatively small. Russian
consumers may benefit from cheaper import prices,
while Russian manufacturers will have cheaper input
goods and can probably improve their productivity.
Some companies in now-protected sectors can also
be expected to be forced out of business. Since
Russia’s most important export goods, oil and gas,
lie outside WTO jurisdiction, exports will not be
affected so much. However, for some sectors such
as steel and chemicals, membership would mean
additional export potential.
The real potential of future WTO membership,
however, is that the service sector will open up to
foreign investments. The removal of various formal
and informal barriers might lead to sizeable improve-
ments in the functioning of the Russian economy,
including generally increased liberalisation and
greater integration into the global economy.
 Ukraine
Eastern European Outlook — March 2007

Growth accelerating despite 2006, positive impulses came from an improved

situation in global metal markets and the recovery of
political turmoil Ukrainian exports. Industrial production increased by
6.2 per cent last year, twice as much as in 2005.
„ GDP growth gaining speed
„ Inflation still high Ukraine: Domestic credit
„ Political situation remains complicated UAH billion
250 250

225 225
Political developments in Ukraine remain hard to
200 200
predict. This has repercussions on foreign relations as
175 175
well as the economic and social climate. Early this
year, the Law on the Cabinet of Ministers surfaced as 150 150

the most important political issue. Unfortunately, the 125 125

law reinforced the conflict between the President on 100 100
one hand, and the Prime Minister and Parliament on 75 75
the other. Despite two vetoes from President Viktor 50 50
Yushchenko, the law was signed by the Speaker of
25 25
the Parliament, thus formally entering into force. 00 01 02 03 04 05 06

One more challenge for the President was the dis- Source: IMF

missal of Foreign Minister Borys Tarasyuk. In De-

cember 2006 Tarasyuk, nominated to his office by the In 2007, the economic situation will change only
President, was dismissed by Parliament. The Presi- marginally. Domestic consumption and investment
dent overruled this removal, but the Cabinet of will be key drivers of GDP growth. The prospects for
Ministers ignored Yushchenko’s objection. There is metal exports are uncertain in 2007-2008, given the
some consensus in the social and political elite regard- likelihood of some deceleration in global growth. The
ing Ukraine’s intention to join the European Union. International Iron and Steel Institute estimates that
However, President Yushchenko and Prime Minister global consumption of finished steel products expand-
Viktor Yanukovich have different opinions about ed by more than 7 per cent in 2006 but will grow by
tactics, which may become an additional source of only 5.8 per cent in 2007. According to analysts
tension in the future. polled by Bloomberg, the price of steel will drop by 2-
3 per cent in 2007 and 5 per cent in 2008. The
Recently the opposition provoked a parliamentary diversification of Ukrainian exports by product groups
crisis. The Yulia Timoshenko Bloc and Our Ukraine and regions is still low, making the country sensitive
factions declared a boycott of sessions of Parliament. to external shocks, particularly in commodities
They were referring to a ultimatum signed by markets.
Timoshenko and Our Ukraine faction leader Vy-
acheslav Kirilenko and handed over to the ruling Ukraine: GDP and inflation
“anticrisis coalition”. Among other requirements the Year-on-year percentage change
14 30
Timoshenko Bloc and Our Ukraine maintain that GDP (LHS)
constitutional reform has led the country into consti- Inflation (RHS) 25
12 SEB
tutional crisis and are demanding that a commission forecast
should be formed to amend the country’s basic law. 20
10
Prime Minister Yanukovich is in a complicated situa- 15
tion. Any decision that the prime minister refers to the 8
Parliament can be blocked by President Yushchenko at 10
the demand of the Timoshenko Bloc and Our Ukraine. 6
5

4 0
Returning to impressive growth
Meanwhile, the economy is back on a fast growth 2 -5
2000 2001 2002 2003 2004 2005 2006 2007 2008
track. According to preliminary estimates, real GDP Sources: State Statistics Committee of Ukraine, SEB
increased by 7.1 per cent in 2006 and at a 9.3 per
cent year-on-year pace in January 2007, mainly driven
by domestic demand. Final household consumption Ukraine and the EU have signed a new agreement on
grew by almost 20 per cent, fuelled by an impressive bilateral steel trade in order to regulate this issue
rise in income and a lending boom. Gross fixed capital before Ukraine joins the World Trade Organisation.
formation expanded slightly less but also contributed The agreement gives Ukraine a 1.32 m tonne quota on
strongly to economic growth. In the second half of steel exports to the EU market, about 20 per cent

8

above the quota for last year. The quota will be
abolished immediately after Ukraine becomes a WTO
member, completely opening access to EU customers.
The European Commission also added milk and eggs
to the list of products Ukraine can freely export to the
EU single market. Due to the slow pace of prepara-
tions, it is not likely that Ukraine will join the WTO
during 2007.
On the other hand, the Ukrainian government intends
to protect domestic producers from external competi-
tion. The list of products subject to import licences in
2007 was expanded as compared to 2006. Although
the official reason for this decision is the need to
strengthen controls on food quality, in fact govern-
ment seeks to impose additional restrictions on
imports as a way to shrink Ukraine’s trade deficit.
Ukraine: Trade balance
USD billion
2.0
1.5
1.0
0.5
0.0
-0.5
-1.0
-1.5
-2.0
00 01 02 03 04 05
Source: National Bank of Ukraine
Thus far, there are no intense discussions about
devaluing the hryvnia, but this issue will linger as long
as the competitiveness of Ukrainian goods is deterio-
rating due to high inflation. Devaluation rumours may
revive in the near future if the government fails to
curb inflation and reduce the country’s current
account deficit. Also, both real and nominal wages are
increasing faster than labour productivity, thus
pushing up unit labour costs and harming competitive-
ness. In 2006, real wages rose 18.4 per cent, repeat-
ing the scenario of the previous year. However, the
average monthly wage was UAH 1,041.4 or EUR 160,
an extremely low level even by Eastern European
standards. Wages in the public sector grew fastest,
while industry lagged behind with “only” 15 per cent
growth in 2006.
According to The Economist’s Big Mac index, the
exchange rate of the hryvnia is 47 per cent below its
purchasing power parity. However, this is not the
best indicator of fair valuation. Ukraine has faced real
appreciation in its national currency since a de facto
fixed UAH/USD exchange rate regime was introduced
in 2001 and CPI growth has exceeded the level of
inflation in the country of its trading partners. Al-
though devaluation would not solve the problem of
Ukraine
Eastern European Outlook — March 2007
excessive wage increases, the authorities might use it
as a short-term tool to correct external imbalances.
Speculative pressure on the national currency might
be triggered not only by economic factors, but also by
further political conflicts between President Yush-
chenko and Prime Minister Yanukovich. Due to
increasing tensions at the top of its political pyramid
and insufficient coordination of foreign policy,
Ukraine is sending mixed signals about its strategic
goals to the international community.
Inflation still high
The government did not succeed in reducing
Ukraine’s annual CPI growth to single digits in 2006.
However, inflation decelerated to 10.9 per cent year-
on-year in January 2007, partly due to lower inflation
on food products. We no longer believe that average
CPI growth will return to 7-8 per cent this year
because of lower inflationary expectations. There will
2.0 be further rises in regulated prices, due to an increase
1.5
in the price of natural gas imports in January 2007. A
slowdown in nominal income growth is hardly
1.0
possible, since wages in certain economic sectors are
0.5 very low and indexation schemes are becoming more
0.0 and more popular.
-0.5
The central government’s fiscal deficit was 0.9 per
-1.0 cent of GDP in 2006 and will be about the same in
-1.5 2007, reflecting positive trends in the economy and
tax administration. The deficit will be mainly financed
-2.0
06
by privatisation proceeds, since the government
envisages offering some strategic companies for sale.
In January 2007, Parliament passed a law allowing the
privatisation of the telecommunication giant Ukrtele-
com, the electrical equipment manufacturer Electro-
tyazhmash and the chemical company Odessa Port-
side Plant.
Liberalisation of the energy market
In January the government introduced several chang-
es in the gas market. Firstly, it is allowing private gas
producers to sell extracted gas by auction. Secondly,
the government has amended its regulation on pay-
ment procedures. Industrial consumers are now
allowed to sign gas supply agreements with gas
traders (Naftogas Ukrainy and UkrGasEnergo) at
prices that include transport and distribution interme-
diaries. Such a decision will enable gas buyers to
establish direct contacts with gas suppliers, thus
improving payment discipline.
9
 Estonia
Eastern European Outlook — March 2007
Mistrusted miracle
„ Postponed euro adoption leads to a reassess-
ment of risks
„ Real wages increase at record pace
„ Mounting external imbalances call for an
adjustment in domestic saving behaviour
Estonia posted a record growth figure of 11.4 per
cent for 2006. This preliminary estimate compares
favourably with the previous peak of 11.1 per cent
achieved in 1997 and is almost twice as high as the
average growth rate of the last 12 years. However,
beneath this bravura performance simmers a less
appetising stew of mounting capacity constraints,
increasing labour costs and accumulating external
imbalances. Indeed, we would suggest an assessment
that while backward-looking indicators – such as
economic growth – may continue to tell a happy story
for a few quarters to come, the underlying tenor may
already have started to change as residents and non-
residents work gradually through the implications of
the uncertainty surrounding euro accession.
Estonia: GDP and inflation
Year-on-year percentage change
14
Inflation
12 GDP
10
8 8
6 6
4 4
2 2
0 0
2000 2001 2002 2003 2004 2005 2006
Sources: Eurostat, Statistical Office of Estonia, SEB
For one, there has been a clear asymmetry in the
perception of risks associated with the missed euro
target. While residents’ nonchalance has barely been
affected, there is surely a palpable sense of heightened
risk among non-resident providers of capital, which
gained further impetus from a mid-February brawl
concerning Latvia’s currency. To the extent that two
leading banks – Swedbank and SEB – are now more
closely scrutinised by increasingly sceptical interna-
tional capital markets as primary drivers behind the
“Baltic economic miracle”, they are likely to yield to
this pressure by further trying to apply the brakes to
the present breakneck credit expansion. Other things
being constant, that would be equivalent to a turna-
round in the monetary policy stance with all the
standard consequences of more restrictive lending,
higher margins and elevated borrowing costs. How-
ever, other things need not remain unchanged, since
less exposed competitors might perceive the retrench-
ment of the market leaders as an opportunity to be
seized. Should this happen, the aforementioned
miracle will be given yet another boost at a time when
the Baltic countries are already making headlines in the
international financial press. Ultimately the credit cycle
will come to a halt, and expectations of residents that
were formed at the peak will have to be reconsidered.
To the extent that permanent income estimates will be
scaled downward, there will be adjustments in saving
behaviour, with a negative impact on domestic de-
mand. In view of this scenario, we are sticking to our
earlier growth forecasts of 8 per cent for 2007 and 7
per cent for 2008.
Labour market grows white-hot
It is nice to be a job seeker these days in Estonia.
Grim memories of a nearly 15 per cent unemployment
rate have recently given way to the more uplifting
experience of double-digit real wage increases. The
present state of the labour market has to be seen
within the context of booming nearby Nordic econo-
mies. The Finnish unemployment rate has fallen to its
lowest level since the late 1980s, and there is a strong
upsurge in demand for construction workers all
across the region. Intense competition with foreign
employers for an increasingly scarce supply of
14 workers has raised real wages, boosted confidence
SEB
forecast 12
and fed into private consumption expenditure.
10 Total employment, which had fallen steadily from its
command economy peak of 840,000 in the late 1980s
to an all-time low of 572,000 in 2000, has now
climbed back to 646,000. Of these 74,000 new jobs,
39,000 were created in 2006 alone as retirees and
discouraged workers were lured back into the labour
force by higher wages. The total number of jobs is
now back at a level last seen in 1994. Other labour
market indicators are singing the same tune. Low
2007 2008 unemployment has lifted the real wage growth rate
from 4 per cent in the first quarter of 2005 to 11.2 per
cent in the fourth quarter of 2006 – the highest in the
past decade. Given our forecasts of sustained Nordic
growth, we expect the Estonian labour market to
remain tight for the next two years, with real wage
growth rates coming down to a less remarkable 7 – 8
per cent.
The rolling headline inflation rate has stayed within the
4.0 – 4.5 per cent corridor in the past two years, but
the more volatile 12-month rate has recently tested a 5
per cent frontier. While this rate is not extraordinary
for a fast-converging economy, it stands out against
just 1 per cent achieved at the outset of 2004 and –
more importantly – remains well above the Maastricht
threshold. Moreover, the last few quarters have
brought about unhealthy shifts among the three
primary inflation-drivers. Given the exchange rate
peg, productivity-based real appreciation is bound to
10
 Estonia
Eastern European Outlook — March 2007

take the form of an inflation differential above the remains a residual vulnerability which will be eliminat-
euro area. But productivity advances are unlikely to ed only when the euro is finally adopted.
account for the entirety of the latest price hikes. The
economy’s high energy intensity exposed it to oil price Estonia: Gross external debt
increases in 2004 – 2005. While this impetus has now In per cent of GDP
90 90
waned, it is increasingly being replaced by rising non-
Banks
tradables inflation. Booming property prices have 80
Total
80
finally lifted rents and found their way into headline 70 70
inflation. In line with our baseline scenario of gradual 60 60
subsiding external financing and consequent adjust-
50 50
ments in domestic saving behaviour, we are lowering
our inflation forecast to 4.0 per cent in 2007 and 3.5 40 40
per cent in 2008. Given an estimated 2.5 – 3.0 per 30 30
cent Maastricht criterion, the inflation target will thus 20 20
remain out of reach. Insofar as the authorities have
10 10
not settled for a new accession date, 2010 is widely
viewed as the earliest possible year. 0
97 98 99 00 01 02 03 04 05 06
0

Sources: Statistical Office, Bank of Estonia

Exchange rate risk revisited

Although the export sector has largely retained its
competitive position, the current account deficit (an
13.8 per cent of GDP in 2006) is too large to be
sustained over the medium term. The current account
deficit moved into double-digit territory at the end of
2002 and has remained there ever since. Persistently
high external imbalances have led to ever higher
external liabilities as a percentage of GDP. As a matter
of common sense, this ratio is bound to hit an upper
limit at some point, and its stabilisation will ultimately
require a shift in the domestic saving-investment
balance.
Gross external debt has climbed steadily, from 50 per
cent of GDP in 1998 to 85 per cent in the third
quarter of 2006. The main driving force behind the
rapid accumulation of external debt has been the
liabilities of banks. The gross external debt of the
banking sector has risen from 18 per cent to 46 per
cent of GDP over the same period. However, the
associated vulnerability to sudden risks is less acute
than these rather unappealing figures would suggest.
Insofar as funding is from parent institutions, these
credit lines are in fact FDI-like and therefore much
less prone to rollover risks. To the extent that the
perceived robustness of the currency board arrange-
ment has encouraged residents to take advantage of a
positive – but by now largely vanished – interest rate
differential between the kroon and the euro, the banks
have built up long foreign currency positions.
Indeed, about 80 per cent of bank loans are in foreign
currencies, with the corresponding shares for short-
and long-term deposits being 30 and 40 per cent
respectively. However, the long foreign currency
position has been achieved at the cost of increased
exposure to credit risks arising from the unhedged
short foreign currency positions of non-banks. While
the currency board system, in principle, alleviates the
risks of open euro positions for all sectors, there
At some point, the edgy feeling among non-resident
financiers is bound to spill over to residents and
induce to them to review the assumptions underlying
their consumption and investment patterns. This is
when the new phase of the cycle will be set in mo-
tion. Insofar as residents will then develop a taste for
local currency liabilities and euro assets, a long-
awaited monetary tightening (i.e. higher local curren-
cy borrowing costs) will take the form of customer-
driven shifts in the banks’ balance sheets.
Given the low prospects of a speculative market
attack on the Estonian currency, we believe the key
issue will be the speed and vehemence with which
residents reassess their beliefs once the credit boom
has run its course. While weakening confidence may
occasionally manifest itself in commotions around
currency exchange booths, the faith in the banking
system’s fundamental health is a far more important
matter. Given the long-term strategic interests of
parent banks in the Baltic region, we consider the
risks of a full-scale banking and currency crisis
remote. A longer period of below-trend growth in
order to bring debt-asset ratios to more sustainable
levels is a better bet.
This assessment is based on the assumption of slower
credit growth and prudent economic policy. There
are, however, signs that the spendthrift habits of the
consumers are increasingly overtaken by growth-
dizzy government. Thus the new four-party coalition
is about to lower income tax and double pensions over
the next four years. This would add fire to the already
procyclical fiscal policy. Precisely at the wrong time.

11
 Latvia
Eastern European Outlook — March 2007
Persistent imbalances despite
political action
„ Feverish and imbalanced growth
„ Severe current account deficit
„ High inflation marginally down
Latvia is showing clear signs of overheating. Explo-
sive growth has provoked huge current account
deficits, persistently high inflation, increased labour
shortages and wage hikes and a dramatic borrowing
and consumption spree. Domestic and international
concerns about the economy recently forced the
government to come up with a programme to reduce
inflation and the imbalances. Although we are not sure
that this plan will help to substantially lower inflation
and ease the imbalances, it has to be welcomed as a
favourable signal from the government, business and
society. Financial market nervousness will return if
the plan remains a paper tiger and if the business and
public sectors do not curb booming consumption.
During the winter, various foreign experts, credit
agencies (Standard & Poor’s, for example, revised its
outlook on Latvia to negative) and banks have predict-
ed a growing risk of a hard landing. In the second half
of February, rumours about a possible devaluation of
the lats drove interbank rates from 4.5 up to 9 per
cent. Although rates soon dropped back to 5.5 per
cent, the lat is still near the upper boundary of its
parity level (Latvia allows ±1% fluctuation around a
central rate).
Latvia: Exchange rate EUR/LVL
0.7125
0.7100
0.7100
0.7075
0.7050
Central parity, 0.7028 ± 1%
0.7025
0.7000
0.6975
0.6960
0.6950
0.6925
Jan Apr Jul Oct Jan Apr Jul Oct
05 06
Source: Reuters EcoWin
The authorities denied that there will be any devalua-
tion, calming the market. In the middle of March, the
Bank of Latvia intervened, since the lat rate reached
intervention level. The bank has always been firm
about maintaining its peg. In 1998 and 1999 it defend-
ed the peg by selling hundreds of millions in foreign
currency when the macro picture was much worse.
In 2006 the bank increased its key interest rate twice
and broadened its reserve requirements for commer-
cial banks, but this has had limited impact on the
consumption and lending boom, since 70 per cent of
newly issued loans are denominated in euros. On
March 15, 2007 the central bank supported the
government’s efforts to curb inflation, raising the refi
rate by further 0.5 percentage points to 5.5 per cent.
Further action will depend on the success of the anti-
inflation plan in curbing price increases, consumption
and lending growth. We expect the Bank of Latvia to
continue to hike its key rate.
The government’s programme to diminish inflationary
pressures and achieve long-term sustainable growth
was unveiled on March 6. The plan was developed by
a group of experts representing ministries, commer-
cial banks, the central bank and the social partners.
Although most domestic and foreign experts agreed
that it was too late to substantially improve the
situation, the plan came at the right time to kill specu-
lation about devaluation. Some measures in the
programme will be implemented in the coming
months, while many will involve medium-term action.
The most important measures concern fiscal policy,
the real estate market, lending, consumption and
competition. There will be a fiscal tightening to
balance the budget in 2007-2008 and achieve surplus-
es in 2009-2010, accompanied by moderate wage
growth in the public sector and prudent public invest-
ments. No tax cuts are expected, though they were
previous promised by the governing coalition. Higher
taxes on speculative deals are expected in the property
market, as well as differentiation of taxes and duties.
To curb lending, there will be stricter requirements on
documentation of income. The plan foresees a step-
0.7125
by-step decrease in inflation to 2.5-3 per cent in 2011,
thus implying euro adoption in 2012 at the earliest.
0.7100
0.7075
In our opinion, the government will achieve its
greatest success in fiscal tightening and reduction of
0.7050 lending, also making some progress in legalising the
0.7025 shadow economy, while its steps to calm and properly
tax the real estate market are of questionable value and
0.7000
too late. In any event, the real estate market is already
0.6975 settling down and there is limited room for prices to
0.6950
rise further.
0.6925
Jan Marginal slowdown expected
07
GDP grew by 11.9 per cent in 2006 and increased by
an average of almost 9 per cent during 2001-2006.
More than ever before, growth is driven by domestic
demand — fuelled by growing personal income, bank
loans, EU funds, untaxed proceeds from the sale of
real estate, income gained through shadowy dealings
and rather rosy expectations. The most prosperous
industries are still the service sector and construction,
while manufacturing is growing only half as fast. Due
to the parliamentary election in 2006, the government
12

was not in a particular hurry to solve economic issues
through legislation, greater competition and lower
inflation. Even taking into account the government’s
latest anti-inflationary measures, more conservative
credit assessments and labour shortages, GDP growth
will slow only to 9.2 per cent in 2007 and 8.2 per cent
in 2008.
Latvia: GDP and inflation
Year-on-year percentage change
14
12
10
GDP
Inflation
8 8
6 6
4 4
2 2
0 0
00 01 02 03 04 05 06
Sources: Eurostat, Central Statistical Bureau of Latvia, SEB
High inflation is a major concern. Since 2004, inflation
has been stuck above 6 per cent. Faint hopes during
the second half of 2006 that the situation might
change soon vanished and rising energy costs again
pushed inflation upward. Consumer prices rose by 6.6
per cent in 2006, only slightly below the previous
year’s level. It was particularly aggravated by rising
food and housing costs, which together accounted for
2/3 of total inflation. The causes of inflation remain
the same: a fast-growing economy, price convergence
towards EU levels, rising living standards and income,
an excess of demand over supply in various sectors,
labour shortages, insufficient mechanisms to compen-
sate for these shortages and a small domestic market
with weak competition. In the next two years, infla-
tion is expected to remain relatively high due to all the
above-mentioned factors plus sharp rises in gas,
heating and electricity tariffs.
Inflation will average 6.5 per cent this year and 5.8
per cent in 2008. A visible decrease of inflation could
occur within 3-4 years, provided that strict measures
are taken and the economy becomes more orderly.
The overwhelming prevalence of imports over exports
pushed Latvia’s current account deficit to an unprece-
dented 20.9 per cent of GDP in 2006. Foreign direct
investments covered slightly more than a third of the
deficit. Booming consumption pushed imports up by
29 per cent in 2006, while exports grew by 13 per
cent. Export growth weakened in the second half of
2006, due among other things to lower demand for
wood products in the EU. Moreover, Latvia will soon
begin to utilise more of the EU funds allocated for the
next several years, which are among the driving
Latvia
Eastern European Outlook — March 2007
forces in the growth of imports. Although public
spending, business volume and consumption will
grow at a slower pace, we do not foresee radical
improvement in the current account. The deficit will
fall only marginally, to 18 per cent of GDP in 2007
and 15 per cent in 2008.
Superheated labour market
The labour force, productivity and wage growth are
14 important factors in maintaining sustainable growth.
SEB The rapid economic upswing and large-scale emigra-
forecast 12
tion of the workforce to other EU countries have
10
activated local labour reserves. Unemployment fell
from 8.7 per cent in 2005 to 6.9 per cent in 2006. We
expect these labour reserves to be exhausted within
two years, while immigration policy will remain rather
strict, resulting in a growing numbers of vacancies.
All the above-mentioned factors pushed up wages by
23 per cent in 2006. It remains an open question
whether Latvia can raise labour productivity quickly.
In some sectors, like construction and services,
07 08 productivity is lagging behind wage growth.
Public finances remain sound. Tax revenue is growing
faster than projected and the implementation of the
anti-inflation plan will improve this. In 2006 there was
a negligible fiscal deficit, because the huge year-end
surplus was distributed within a few weeks by the
government, which thus kept its pre-election promis-
es. The government has a good chance of achieving a
balanced budget as early as this year and a small
surplus in coming years, as tax revenue is strong and
public spending is expected to be more prudent.
The ruling coalition of four centre-right pa.rties led by
Prime Minister Aigars Kalvitis (Peoples Party) felt
comfortable having 58 votes of 100 and sometimes
enjoying indirect support from the opposition leftists.
The only pragmatic oppositionists, the New Era
reformists, was totally ignored. The party lost the
post of Mayor in Riga city and was pushed into
opposition. However, recently the government’s
attempt to get more direct control over national
security got a negative reaction from the public and
the President of Latvia, resulting to the possibility of a
referendum. If it leads to early elections that would
favour the opposition. Otherwise, the crucial issues
for the cabinet in the coming years are the anti-
inflation programme and the Border Agreement with
Russia.
13
 Lithuania
Eastern European Outlook — March 2007
Solid growth but
accelerating inflation
„ GDP growth starts to slow
„ Inflation will set record for this decade in 2007
„ Budget in balance
In 2006, a four-year period of very rapid economic
expansion approached its end. The Lithuanian econo-
my is starting to face changes in its fundamentals.
The trade and current account deficits have widened
as export growth has gradually subsided while im-
ports have continued to flourish. An economy cannot
be eternally driven by its own domestic consumption
boom; increasing trade and current account imbalanc-
es will, in the long run, deal a blow both to financial
stability and to the domestic market itself. Thus, the
economy has already peaked and growth will decrease
slightly in 2007-2008. The export growth rate should
slow, while import expansion will stay robust. Mean-
while, increased interest rates and decelerating growth
in credit portfolios will have a negative effect on
domestic demand. This process will be gradual and
will not suddenly cool down the economy.
Lithuania: GDP and inflation
Year-on-year percentage change
12 GDP (LHS)
Inflation (RHS)
10
8
6 GDP this year and 8 per cent in 2008. Our previous
4 2007 and 6.5 per cent in 2008 is still realistic, though
2 -1
0 -2
2000 2001 2002 2003 2004 2005
Sources: Statistics Lithuania, Eurostat, SEB
In recent years, the Lithuanian and the broader Baltic
“economic miracle” has been conditioned by a combi-
nation of favourable factors: the EU market has
opened up fully, there has been an economic upswing
in the formerly Soviet CIS countries, the macroeco-
nomic environment has been stable, etc. All this,
however, would have been not enough to achieve 7-8
per cent annual GDP growth without the lending
boom. Credit activities follow the business cycle, and
some signals showing a possible deceleration in
banking activities have already started appearing. Price
stabilisation in the residential property market
squeezed the growth of the housing loan portfolio
from 87 per cent in 2005 to 61 per cent in 2006. This
year, the total credit portfolio should expand by 30-35
per cent; in 2006 it grew by 49 per cent.
During a recent visit to Lithuania, the International
Monetary Fund mission pointed out that there has
been a decline in export competitiveness as salaries
have outpaced labour productivity growth. Basically,
we share this view. However, Lithuania has few
mechanisms to regulate wage growth. Attempts to
limit pay increases in the public sector would cause
highly qualified professionals to move to the private
sector, encourage emigration of doctors and teachers
and trigger a decline in the quality of public services.
Agreements on smaller wage increases in the private
sector are also hardly achievable, due to labour
shortages.
Real GDP rose by 7.5 per cent in 2006. Construction
was the fastest growing sector, followed by manufac-
turing and financial intermediation. For several years,
economic growth seemed to follow a straight line.
The GDP increases in 2004, 2005 and 2006 reached
7.3, 7.6 and 7.5 per cent, respectively. On the other
hand, some trends are present that paint future
prospects as more clouded. Seven or eight months
ago, we forecasted that growth would slow in the
second half of 2006 as compared to the first half, and
this proved true: in the first quarter, the rate of GDP
increase was 8.5 per cent, while in the second, third
and fourth quarters it was 8.4 per cent, 6.4 per cent
and 6.9 per cent, respectively. The most important
factor behind slower growth was the deterioration in
5 net exports. A slowdown in manufacturing late in the
SEB
forecast
year and a slump in agriculture had the largest nega-
4 tive effect on GDP growth. By way of comparison,
during 2005 growth was accelerating.
3
2
The current account deficit will reach 10 per cent of
1 forecast that GDP will increase by 7.0 per cent in
0
on the optimistic side. Private consumption and gross
capital formation will remain key drivers, while the
expectations of business and households will remain
positive.
2006 2007 2008
Lithuania: Current account balance
Per cent of GDP
0 0
-2 -2
-4 -4
-6 -6
-8 -8
-10 -10
SEB
forecast
-12 -12
2000 2001 2002 2003 2004 2005 2006 2007 2008
Sources: Bank of Lithuania, SEB
14

In the next couple of years, the future of the second
reactor at the long-obsolete Ignalina nuclear power
plant and the new nuclear power plant construction
project will remain a vital issue in the economy. It is
becoming more and more obvious that Lithuania may
suffer an energy shock. A shutdown of the Ignalina
reactor at the end of 2009, with a new power plant
starting operation only in 2015-2016, would mean that
the country would have to survive without nuclear
power for 5 to 6 years. Demand for natural gas would
significantly increase, and it is difficult to forecast the
price of gas. Last but not least, environment pollution
would worsen. GDP growth would decrease due to
lower energy production and faster inflation.
Increasing price pressure
In 2006, average annual inflation was 3.8 per cent.
Unlike in previous years, there was a major rise in
food prices: 8.1 per cent. Utility prices rose even
faster at 10.3 per cent. Keen international competition
helped lower clothing prices by 3 per cent. Thanks to
lower global oil prices, there was only a moderate
increase in transport costs.
The above-mentioned changes confirm that Lithuanian
inflation is driven mostly by cost-push factors. Food
products were especially sensitive to the surge in
prices of agricultural products and higher costs in the
food processing and distribution system. Meanwhile,
demand-pull factors had little effect on food price
inflation.
In 2007, inflation will hit a record for this decade of 4
per cent or even a bit higher. The rise in consumer
prices will be mainly spurred by higher natural gas,
heating and electricity prices; an increase in tobacco
excise duties; and higher unit labour costs.
Lithuania: Wages
Year-on-year percentage change
20.0
17.5
15.0
12.5
10.0
7.5
5.0
2.5
0.0
01 02 03 04 05 06
Source: Statistics Lithuania
In the fourth quarter of 2006, wages were up by 19.1
per cent year-on-year. We expect pay increases of 15
per cent in 2007 and 13 per cent in 2008. The main
reason behind slower wage growth will be less room
for continued legalisation of wages paid “under the
Lithuania
Eastern European Outlook — March 2007
table”, rather than changes in the demand for labour.
Demand-pull factors will continue to play a secondary
role in inflationary processes. Thus the recent com-
pensation for lost rouble savings (LTL 1.135 billion, or
5 per cent of country’s annual wage bill) should have
no adverse effect on the consumer price index. The
same holds true for the effect of a possible personal
income tax cut from 27 to 24 per cent.
Recently, the central bank and the Ministry of Finance
have considered some actions to preclude further
acceleration of inflation. Firstly, any automatic indexa-
tion of salaries should be avoided. The government
intends to use windfall revenues to reduce the budget
deficit. The central bank is committed to applying
stricter standards of capital adequacy and reserve
requirements than in the euro zone. Also, there is
ample room to improve control of administratively
established energy prices.
In 2006, the fiscal deficit was slightly lower than we
forecasted in last autumn’s Eastern European Out-
look. According to preliminary data, the budget was
more or less balanced. The 2007 budget includes a
conservative projection of revenues from personal
income tax. We believe that the fiscal situation will be
very much like that in 2006 with actual revenues
exceeding projections and the fiscal deficit being only
of a symbolic size.
The key political event in early 2007 was the local
elections held on February 25. On the one hand, it
was a good opportunity for the political parties to test
their popularity before the parliamentary election
scheduled for the autumn of 2008. On the other, the
election results showed public attitudes towards the
activities of the existing municipal councils and city
mayors.
The election did not indicate any obvious trend.
Formally it was won by the conservative Homeland
20.0 Union party. However, the ruling Social Democrats
17.5 were very close behind in the number of votes and
actually outscored the conservatives in terms of seats
15.0
on municipal councils. Given the victory of the
12.5 conservatives and Social Democrats at the municipal
10.0 level, the two parties can be expected to be the main
rivals once again in next year’s parliamentary election.
7.5
5.0
2.5
0.0
15
Theme: Overheated in the Baltics
Eastern European Outlook — March 2007
Credit growth must
come down
„ Most heat being generated by birth of Baltic
retail banking market
„ Credit cycle peaking
„ Latvia most overheated
The Baltic economies are sizzling. In Estonia and
Latvia, yearly growth rates have been in double digits
since 2005. Confidence surveys and real wage growth
are reaching their highs for the decade, asset prices
are going through the roof and unemployment is about
to be erased from the economic vocabulary. Since at
least mid-2006, however, a growing chorus of
dissenting voices has claimed that the current pace of
expansion is not sustainable and that the three econo-
mies display increasingly alarming symptoms of
overheating. This implies that aggregate demand is
outpacing supply and, as a result, mounting capacity
bottlenecks are bound to hamstring the present pace
of expansion.
The overall conclusion from a reading of three
conventional indicators of overheating – economic
growth, inflation and current account balance – is that
in the past three years, the Baltic economies have
indeed undergone a major growth surge. In 2001-
2003 there was little cross-regional variability in
economic growth rates, but in 2004-2006 Latvia and
Estonia forged ahead. Their average growth rates
climbed two percentage points, while that of Lithuania
actually declined (from 7.9 to 7.5 per cent). Capacity
constraints are higher than at any time this decade,
and severe labour shortages have caused real wages
to skyrocket. In all three economies, unemployment is
falling to levels not seen since the early 1990s. Strong
demand for labour coupled with a natural population
decline and a negative net balance of international
migration have pushed Estonian real wage growth
above 10 per cent. The other two economies are
experiencing similar labour cost pressures.
Higher inflation
Inflation performance has deteriorated in all three
countries, although in Estonia only to a minor extent.
On the other hand, Latvia’s average inflation rate shot
up from 2.5 per cent in 2001-2003 to 6.6 per cent in
2004-2006. Although the Lithuanian inflation rate has
also risen perceptibly, it is still the lowest of the three
countries. With the possible exception of Latvia, Baltic
inflation rates are not extreme for fast-converging
economies. The problem is, however, that they are
too high to meet the Maastricht criterion for euro zone
accession and are creating extra uncertainty about
future exchange rate arrangements.
16
However, overheating may be a more serious issue
than the inflation figures suggest. In small open
economies, domestic demand pressures are as likely
to show up in wider current account deficits as in
higher inflation. Thus, perhaps the unstoppable
accumulation of external imbalances, fuelled by credit
growth and pro-cyclical fiscal policies, is where the
most visible signs of overheating are to be found.
Again, Latvia stands out, with an average current
account deficit that has almost doubled from a
sustainable 7.5 percent of GDP to 14.5 per cent.
While the other two Baltic economies have also
accumulated debt, Lithuania has, up to last year, so
far been able to keep its current account deficit in
single-digit territory.
The Baltic countries: Indicators of overheating
Per cent
16 16
Estonia
14 Latvia 14
Lithuania
12 12
10 10
8 8
6 6
4 4
2 2
0
2001-2003 2004-2006 2001-2003 2004-2006 2001-2003 2004-2006
0
GDP growth Inflation Current account/GDP
Sources: National statistical offices, SEB
Heavy and increasing dependence on foreign savings
has to be seen against the backdrop of deepening
integration with EU product and financial markets.
Catching-up economies are expected to run larger
external deficits because of their more rapid growth
prospects. In a dynamic framework, current account
sustainability depends on expectations of future
domestic and world growth, a country’s cost of
borrowing and the sensitivity of trading partners to
relative price changes of locally produced goods.
Hence, if the expected growth differential with the
rest of the world is sufficiently high, a country could
get away with a fairly high external deficit. Low
borrowing costs would have the same effect. The
commodity structure of exports is equally important.
If a country competes primarily on the basis of cost,
real appreciation associated with the convergence will
have a relatively large adverse impact on its external
deficit.
Thus, the sharp deterioration in the external position
of the Baltic countries is largely an expectations-
driven phenomenon. Insofar as non-resident lenders
and resident borrowers have formed their expecta-
tions in a backward-looking manner, the recent large
reported growth differential may have led to unrealis-
tic beliefs about its durability. Even if today’s current
 Theme: Overheated in the Baltics
account deficits may be sustainable given expectations
of continued strong economic growth (admittedly a
big if), less optimistic expectations could call their
sustainability quickly into question. Moreover, rapid
convergence associated with large-scale use of
foreign savings is likely to exert a feedback effect on
growth expectations, as worries about heightened
financial vulnerabilities come to the fore.
Trapped in a credit cycle
There is, however, one single factor behind both
actual and expected growth performance – the
spectacular drop in the cost of credit. Whatever
beliefs residents may have had during the 1990s about
their income growth and future opportunities, there
was little room for inter-temporal substitution in a
double-digit interest rate environment. Around 2000,
liquidity constraints began to collapse, first in Estonia,
then in Latvia and finally in Lithuania. By 2002 money
market interest rates in the three countries were less
than 90 basis points above Euribor (compared to
almost 2000 basis points only three years earlier). The
ready availability of cheap cash unleashed the private
sector’s pent-up demand for goods. The resulting
surge in domestic demand boosted growth rates, real
wages and, perhaps most importantly, projections of
permanent income. Upwardly revised expectations
about future consumption led, in turn, to a new phase
of the cycle.
Insofar as all three countries seem to be testing the
outer limits of financing constraints, two major
factors behind the credit boom are likely to gradually
fade. If borrowing costs will not rise because of more
restrictive lending, increased uncertainty surrounding
the exchange rate arrangements of the Baltic countries
will, at some point, show up as greater demand for
local currency liabilities and foreign currency assets
on the part of the non-bank private sector. These
shifts will then gradually re-introduce interest rate
differentials and cause resident borrowers to re-
estimate their life-time incomes. At this point the
credit cycle will turn, as sober assessments of future
income would then decrease the demand for goods
and labour and limit the growth of real incomes.
When this happens, the flexibility of the Baltic econo-
mies will be put to the test. A drop in domestic
demand would call for a shift of resources from the
non-tradable into the tradable sector. This is the point
at which the exchange rates of the Baltic countries
may experience downward pressure. In principle,
restoration of lost competitiveness can occur either
via stagnating wages and prices or one-off changes in
the exchange rate. To the extent that it is easier to
change one price rather than a multitude of them,
devaluation is often viewed as an attractive way out of
an exporter’s predicament.
17
Eastern European Outlook — March 2007
Whatever the theoretical merits of this argument, we
think that – given our optimistic global scenario – the
Baltic countries’ currency pegs will have a good
chance of survival. Firstly, although growth has
undoubtedly been skewed towards domestic sources
in recent quarters, robust export growth rates indicate
that there has not yet been a massive misallocation of
resources. There are, however, signs that cost
pressures are taking their toll. In 2006 export growth
rates fell in all three economies — in Latvia quite
spectacularly (from 34 to 13 per cent). Hence, the
longer the adjustment is delayed, the stronger the
subsequent pressure on the exchange rate. Secondly,
if the Nordic economies continue to grow at a brisk
pace, relative price disadvantages will be offset by
persistently strong demand from these countries. This
will probably give Baltic exporters some extra leeway
in adjusting to harsher realities.
Baltic countries: Private credits
Year-on-year percentage change
100 100
75 75
50 50
25 25
0 0
-25 -25
-50 -50
-75 -75
95 96 97 98 99 00 01 02 03 04 05 06
Lithuania Latvia Estonia
Source: IFS
An examination of credit growth rates suggests that
the high point of the cycle may already be past. In
Estonia and Lithuania, the twelve-month growth rate
of private credit peaked in mid-2006, and in Latvia
growth also seems to have stabilised. However, while
slowing, the credit expansion is still far too rapid to be
sustainable in the medium term.
Given the competing soft and hard landing scenarios,
for Latvia and Estonia with the hard landing involving
substantial stress on the currencies and possible
devaluation, we anticipate a gradual revision of
growth expectations, with accompanying slower
growth and easing of external imbalances over a
period of 2-3 years. But this forecast assumes a
continued slowdown in credit expansion. Should the
latter experience a further boost – an outcome we
consider unlikely at the moment – the probability of a
more violent adjustment can only rise. In Latvia,
authorities recently came up with a restrictive anti-
inflation package. Given the increasing awareness of
the threats associated with the present boom, the
other two Baltic governments may soon follow suit.
 Poland
Eastern European Outlook — March 2007
Growth above trend
„ Strong domestic demand
„ Great need for tightened public finance
„ Euro adoption no earlier than in 2012
In 2006, the Polish economy was characterised by
fast growth, low inflation and a relatively narrow
current account deficit. This year, GDP growth will
remain at a high level thanks to a continued increase in
private consumption and large fixed capital spending.
Rapid growth and rising wages will put an end to the
moderating trend in prices. The recent pattern of
vigorous domestic demand triggering a deterioration in
external accounts may strengthen somewhat. While
not a reason for immediate concern, populist public
spending and the political dependence of the National
Bank of Poland (NBP) should be watched closely.
Setting a definite date for euro adoption could serve as
an anchor for sound economic policy and reforms.
Poland: GDP and its components
Year-on-year percentage change
15
10
5 5
0 0
-5
-10
-15
Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1
02 03 04 05
GDP Public consumption
Private consumption Fixed capital formation
Source: Central Statistical Office
Last year GDP growth was 5.8 per cent, the highest
since 1997. The buoyant dynamics of exports finally
started to translate into domestic demand, mainly fixed
capital formation. The country’s EU accession in 2004
prompted huge inflows of foreign direct investment
and demand for Polish goods. Record-low interest
rates as well as inflows of EU structural funds boost-
ed investment expenditure, and more intense hiring of
labour encouraged private consumption.
In 2007, GDP will grow at the same pace as last year.
The economy will keep accelerating; in October-
December 2006 it speeded up year-on-year for the
seventh consecutive quarter, reaching 6.4 per cent.
Around mid-year it will slowly start losing momen-
tum, mainly due to statistical base effects and a lack
of additional stimulus. Recently tense Polish-Russian
relations may also hamper GDP growth, due to slower
exports. According to the Russian press, Russia is
considering an additional embargo on Polish merchan-
dise exports, mainly construction materials and
pharmaceuticals. The latter make up roughly one half
of exports to Russia. The intended embargo is widely
interpreted as Russia’s reaction to Poland’s veto of
the “energy charter” between Russia and the EU.
Poland blocked the negotiations after Russia had
imposed an embargo on Polish meat products at the
end of 2005.
Large inflow of EU funds
In 2008, GDP growth will be somewhat less than in
2007 but will stay above the trend level of 4-5 per
cent. Both cyclical and structural factors will be the
main drivers. If Poland improved its absorption of EU
structural funds from less than 50 per cent in 2006 to
100 per cent, its economic growth would be even
faster, possibly 7.0 per cent. Poland is the largest net
recipient of money from the 2007-2013 EU budget.
The EU funds should be one of the main factors
sustaining large investment expenditure.
Export growth started to lag behind import growth in
the second half of last year, thus interrupting the
narrowing trend in the current account deficit. In the
15 third quarter of 2006, the current account deficit
measured 1.4 per cent of GDP, close to our full-year
10
forecast. This year it will deepen further, with a
negative contribution from net exports. Nevertheless,
substantial inflows of EU funds and remittances from
Polish emigrants will keep the current account deficit
-5 at one of the lowest levels among new EU members.
-10 Despite fast growth and adverse labour supply effects
caused by emigration, unemployment remains the
-15
Q3 highest in the expanded EU (15.1 per cent in Janu-
06 ary). In 2007 and 2008 the jobless rate will shrink
further, but at quite moderate speed due to a high
degree of structural unemployment.
Last year’s average annual HICP inflation was 1.3 per
cent, one of the three lowest in the EU. Despite
emerging labour shortages in certain economic
sectors, productivity growth offset wage growth,
thus taming inflationary pressures. This year inflation
will go up, however. In addition to higher excise taxes
on gasoline and cigarettes imposed in January,
inflation will accelerate due to demand-pull factors.
The key issue within the NBP’s Monetary Policy
Council is whether inflation will exceed the upper
band of its 2.5 +/- 1 per cent target range, based on
headline annual inflation measured as CPI. Recently
the annual inflation rate mainly hovered below target,
but it squeezed back into the preferred range in
January (1.7 per cent). Taking this into account, in
February the MPC left the reference rate unchanged
at its 4 per cent record low, where it has remained for
12 consecutive months. The MPC’s accompanying
statement was very similar to that of the previous
18

month. According to the central bank, there is not
enough solid evidence that strong economic growth is
threatening its inflation target.
Poland: Inflation
Year-on-year percentage change
5.0
4.5
4.0
3.5
3.0
2.5 Central bank's
2.0
target range
1.5
1.0
0.5
0.0
02 04 06 08 10 12 02 04 06 08 10 12 02 04 06 08 10 12
04 05 06 07
Source: Central Statistical Office
Headline inflation (CPI) will peak in the second
quarter of this year, at close to the central bank’s
target. Then the MPC will hike the reference rate by
25 basis points (from 4 to 4.25 per cent) after releas-
ing a new inflation report in July. High unemployment
and tough global competition will limit the speed of
wage increases, while continuous productivity growth
should be maintained given buoyant investment
expenditure. Thus, despite the predicted acceleration,
inflation should stay within safe territory, meaning no
additional interest rate hikes in 2007.
Since the appointment of Slovomir Skrzypek as
Poland’s new central bank governor in January 2007,
the balance of votes in the MPC has shifted in favour
of the doves. At present, seven out of the ten MPC
members back a “neutral” monetary policy stance.
The market views Skrzypek as having neither a
sufficient academic background nor enough experi-
ence in monetary policy to form his own firm opinion
as to where interest rates should be heading. Even
worse, Skrzypek’s close ties with President Lech
Kaczyncki and the government are likely to trigger
concerns about the central bank’s independence.
The 2006 fiscal deficit was markedly below the
government’s target. It reached PLN 25 billion and
was PLN 5 billion lower than projected. The better-
than-targeted fiscal balance was good news on the
surface, but a closer look reveals some major weak-
nesses in the planning process. Despite much faster
than expected GDP growth, the revenue surplus
above plan in 2006 was half that of 2005. Similarly,
the government overestimated certain expenditures
such as subsidies on agricultural fuel and family
allowances. Poland’s strong economic performance
will ensure sufficient budget revenues at least in the
short run, thus providing favourable conditions for
fiscal reforms. The approved 2007 budget contains no
major steps towards fiscal tightening, however. The
Poland
Eastern European Outlook — March 2007
government boosted spending more than the nominal
GDP growth assumed in the budget and left the same
PLN 30 billion deficit cap in place. By April of this
year, the authorities have to comply with an EU
accounting rule that stops them from classifying
transfers to private pension funds as state revenue. As
5.0 a result, the fiscal deficit to GDP ratio will be roughly
4.5 1.9 per cent deeper. Thus the deficit will not reach the
4.0 3 per cent threshold of the euro zone convergence
3.5 criterion, either in 2007 or 2008.
3.0
2.5
If there were enough political will, Poland could fulfil
2.0
all the Maastricht criteria with relative ease. And if the
1.5
government set a clear target date for joining the euro
zone, this would be a sign of a shift towards solid
1.0
economic reforms, above all in the sphere of public
0.5
finance. However, this is not likely to happen before
0.0
the parliamentary election, scheduled for autumn
2009. We do not regard euro adoption as likely earlier
than 2012. The only clear thing today is the govern-
ment’s intention to hold a referendum on euro adop-
tion in 2010, despite the disapproval of Brussels and
Poland’s commitment to join the euro zone when
accepting EU membership in 2004.
Poland’s wobbly coalition government is currently its
largest economic risk factor. The appointment of the
central bank governor and the 2007 budget were two
recent sources of tension within the coalition. Future
areas of government disagreements will be public
spending, energy, property restitution and privatisa-
tion. Although a premature parliamentary election
cannot be entirely ruled out, we do not foresee one
taking place in the near term. Local elections in
November 2006 led to an outcome very close to the
current parliamentary situation. Thus, no political
parties are sure they would win early elections.
Despite political uncertainties, early this year Fitch
Ratings upgraded Poland’s classification. The coun-
try’s creditworthiness is improving due to its strong
growth as well as low external financing risks.
This year the zloty will strengthen due to solid eco-
nomic fundamentals. However, in the course of the
year the currency may temporarily drop against the
euro as a response to political turmoil or fiscal easing.
19
 Slovakia
Eastern European Outlook — March 2007
Record-breaking growth
„ Sentiment indicator at new all-time high
„ Increasing chance of euro introduction by 2009
„ Continued strong koruna also after
revaluation
Slovakia’s economic growth and prospects have
never been better. The country certainly has the
fastest growth in Central Europe. The probability of
joining the euro zone is increasing as inflation slows,
but the fiscal deficit remains a challenge. In order to
achieve more balanced growth, fiscal consolidation
and continued labour market reform are needed.
However, political stability is supporting the positive
trends in the economy. Public administration has
improved, the tax system has been simplified and
foreign investment is warmly welcomed.
The economy grew by almost 10 per cent in the
second half of 2006 and by 8.3 per cent for the year,
primarily driven by export-oriented manufacturing
(cars and electronics) but also by continuing expan-
sion in domestic demand. The economic sentiment
indicator rose to a new high. We expect continued
strong growth in the next few years, mainly due to
brisk export growth. Household demand and fixed
capital investment will grow somewhat more slowly.
GDP growth will reach 8 per cent in 2007 and 6.5 per
cent in 2008.
The current account deficit decreased only slightly in
2006 but is not a threat, since there were also massive
foreign direct investment inflows, mostly in car
production. Expected strong export growth will help
cut this deficit greatly in the next few years, thanks to
accelerated car production by the PSA and Kia
factories. Samsung also recently decided to invest in
Slovakia, confirming the competitiveness of the
country. In 2006, FDI inflow was twice as large as in
2005, covering 2/3 of the current account deficit.
This deficit will shrink from 7.9 per cent in 2006 to
4.5 per cent in 2007 and 3.5 per cent in 2008.
The rapid economic growth has resulted in record-
high employment. Reductions in social benefits and
stricter rules that force the unemployed to seek jobs
faster contributed to a drop in unemployment from 18
per cent in 2004 to 13.5 per cent in 2006. The contin-
ued outflow of labour also decreased the jobless rate.
Nevertheless long-term unemployment remains a
serious problem and is the highest in the EU. Wage
increases are not a big concern, as productivity
growth is faster.
Inflation is no longer the biggest obstacle on the road
to euro adoption. Slovakia is sticking to its 2009 euro
zone entry target. Benign fuel prices, base effects in
20
gas and heating prices and a strong koruna are all
contributing to lower inflation. Decreases in regulated
prices and lower fuel and service price expectations
are lowering inflation forecasts. Food prices remain
almost the only concern. Inflation will drop to 2.5 per
cent in 2007 and 2.3 per cent in 2008. Thus there is a
high probability that the country will meet the Maas-
tricht inflation criteria in 2009.
The euro adoption target requires stronger fiscal
discipline, since the budget deficit is still above 3 per
cent of GDP. Although the government has carried out
some of its pre-election promises, fiscal planning and
controls have tightened. Also yielding a positive
impact were a reform in public finance and the
introduction of a flat tax that has been accepted by
households. Parliament easily approved the 2007
central government budget. Tax revenue is expected
to increase more than planned, but spending will also
tend to increase. The government intends to trim
capital spending in favour of domestic consumption.
Strong economic growth will allow a lowering of the
public sector budget deficit from 3.4 per cent last
year to 3 per cent in 2007 and 2.8 per cent in 2008.
The koruna has appreciated sharply since autumn,
moving towards the lower boundary of the central
ERM2 parity level. Thus, the central bank has tried to
ease the appreciation pressure on the SKK. On March
19, Slovakia revaluated by 8.5 per cent to a new
central parity at 35.4424 against the euro. However,
with strong fundamentals such as healthy growth and
low inflation, the koruna will remain under strong
upward pressure. The central bank has not changed
its key interest rate since September 2006, since
current economic developments are in line with its
mid-term forecast. We expect the key rate to be cut to
4.25 per cent in the second half of the year.
Government surprisingly strong
Contrary to expectations the rainbow coalition con-
sisting of the left-wing populist party Smer-SD led by
Prime Minister Robert Fico, the former communists
and the nationalist Slovak National Party has strength-
ened its position, maintaining a popularity of above 60
per cent. The coalition also won the recent local
elections. Although the government, which came into
power in June 2006, opposed many of its predeces-
sor’s reforms, it is still maintaining the goal of intro-
ducing the euro in 2009. It has not made any major
changes in the previous government’s reforms aimed
at improving the business environment and attracting
foreign investments. A budget tightening is necessary,
but this goes against the government’s pre-election
promises to expand the welfare state and cut taxes.
 The Czech Republic
Eastern European Outlook — March 2007

Past its peak coming months due to housing deregulation, tobacco

„ Domestic demand the key driver
„ Inflation below central bank target
„ Concerns about political stability remain
The peak of the business cycle is past, and the
growth of the Czech economy is slowing. Inflation
remains well below the target of the Czech National
Bank (CNB) but with a rising trend in the coming
months. The main risk lies in continued political
instability, since the new government lacks a majority
in Parliament to introduce its reforms. The govern-
ment has not set a new euro zone entry target date,
but it will not be earlier than 2011.
The Czech economy has maintained steady growth,
driven by accelerating household consumption and
robust investment activity. Manufacturing industry is
performing well, fuelled by investments in exportori-
ented capacity. The contribution of net exports to
GDP was slightly negative, due to a rise in imports
driven by increasing domestic demand. Consumption
is burgeoning, fed by solid wage growth, cheap loans,
rising employment and strong consumer confidence.
We expect economic growth to moderate to 4.8 per
cent in 2007 and 4.5 per cent in 2008.
Higher repatriation
Last year foreign trade reached a record-breaking
surplus, with machinery and cars as the main contrib-
utors. In spite of this, the current account deficit
more than doubled due to deterioration in the balance
of services and unexpectedly large shortfalls in the
income balance, since profits were repatriated by
foreign investors. The current account deficit will
decrease only marginally in the next couple of years,
due to a continuous outflow of profits from well-
performing foreign-owned companies.
Unemployment continued to shrink last year due to
strong demand for labour. However, there were still
structural imbalances, since long-term unemployment
continued to rise. Although the growth in real wages
was the highest in the past three years, productivity
growth was even higher, especially in manufacturing.
Inflation was low in the second half of 2006, mainly
due to the earlier strengthening of the koruna and
harsh competition in the retail trade. The CNB low-
ered its inflation target to 2 per cent as from 2010,
hoping to reduce inflationary expectations. A revision
of the consumer basket will give housing costs,
transport and tobacco a larger impact on inflation,
while the role of food and clothing will diminish. The
net effect of these changes will probably be slightly
higher price increases. Inflation will increase in the
taxes, food prices and services. We expect inflation to
remain slightly below 3 per cent: at 2.8 per cent in
2007 and 2.7 in 2008.
Modest inflation keeps rates low
The CNB has not raised its key interest rate since
September 2006 but has maintained it at 2.5 per cent,
the lowest in the EU. A sharp decline in inflation and
the strengthening of the koruna are keeping the central
bank in a wait-and-see position. However, the pros-
pect of higher inflation will trigger an increase in the
key rate to 3 per cent by the end of the year.
Public finances are still the Achilles heel of the Czech
economy, due to the lack of consensus among
politicians. The fiscal deficit exceeded 3 per cent of
GDP, mainly due to extra spending on pensions. The
2007 central government budget draft — reflecting
the fragile situation in Parliament — avoided a restric-
tive budget regime and supported social spending.
One significant budget risk is hidden in the planned
income from the privatisation of the large energy
company CEZ, which is uncertain both in terms of
timing and size. Therefore we expect the fiscal deficit
to remain above 3 per cent in 2007 and 2008.
Political uncertainty remains
After eight months of political crisis, a new coalition
of the centre-right Civic Democratic Party (ODS), the
centrist Christian Democrats and the Green Party —
led by Prime Minister Mirek Topolanek — won a
parliamentary vote on January 19. However, political
uncertainty will persist, since the coalition has only
100 of the 200 seats in Parliament and enjoys only the
shaky support of two renegade MPs. There is a
limited chance that the government can push through
a package of economic and social reforms. The
probability of early elections is thus high.

21
 Hungary
Eastern European Outlook — March 2007
Combating twin deficits
„ Fiscal consolidation taking place
„ Slowing growth, faster inflation
„ Government gaining credibility, but not
popularity
The rigorous fiscal reforms applied since September
2006 are starting to hamper economic expansion and
push up inflation. Real GDP growth slowed down to
3.9 per cent in 2006, and inflation rose to 4.0 per
cent. Growth and inflation are yet to get worse in
2007. However, fiscal consolidation is proceeding
rather successfully and should drive Hungary’s twin
deficits to slightly less worrisome levels this year.
In 2006, growth was mainly driven by external
demand. Exports were helped a lot by a relatively
weak forint and favourable developments in the euro
zone, Hungary’s most important trading partner.
Domestic demand decreased slightly in absolute terms
as fiscal tightening started to bite.
This year, GDP growth should slow sharply to 2.3 per
cent and remain rather weak in 2008 at 2.8 per cent.
In the next few years, external demand will continue
to drive economic growth in Hungary, since domestic
demand will be depressed by fiscal consolidation and
still relatively high interest rates.
In the first nine months of 2006, the current account
deficit was a rather high at 8.6 per cent of GDP. The
positive effect of improved net exports was easily
offset by large outflows of foreign direct investment
income. However, the beneficial impact of exports in
the fourth quarter probably shrank the current ac-
count deficit to around 7.5 per cent of GDP for the
whole year. In the next few years, smaller outflows of
FDI income can be expected, due to improved
investor sentiment towards Hungary. Net exports
should also contribute positively to the current ac-
count, thus bringing the deficit down to 5.5 per cent
in 2007.
Inflation surged to 8.4 per cent year-on-year in
January, driven by higher taxes and the elimination of
subsidies on gas, transport, medicines etc. Price
growth should peak at 9 per cent in March 2007.
Thus far, lower oil prices, a stronger forint and
subdued domestic demand are helping to mitigate the
negative impact of fiscal tightening on inflation. In the
second half of this year, inflation is expected to ease
due to statistical base effects, but for the whole year it
will remain high, amounting to 7.0 per cent. In 2008,
average HICP inflation should slide to 4.3 per cent due
to favourable base effects and weak demand.
Last autumn’s political turbulence was replaced by
relative tranquillity after Prime Minister Ferenc
22
Gyurcsány managed to survive a parliamentary
confidence vote. In February, Gyurcsány received
additional support from his party, being elected to
head the Socialist Party by a large majority of votes.
Despite a comparative easing of political tensions, the
government remains rather vulnerable. Opinion polls
reveal that the popularity of the ruling coalition is at
record lows and that there is increasingly high support
for opposition parties. The repercussions of the
government’s fiscal austerity package are the main
factor behind public disapproval of the ruling parties.
Tightening continues
Last year seems to have been the first since 2001 that
the government did not breach its planned budget
deficit limit. The government’s forecast for 2006 was
10.1 per cent of GDP (ESA’95 standard, pension
costs included), while the preliminary results came in
at 9.6 per cent of GDP. Thus, despite the deficit still
being huge, the government is starting to prove its
credibility and its determination to deal with the
imbalances.
Almost on a weekly basis, EU officials continue to
press the Hungarian authorities to tackle imbalances.
We predict that the government will continue to move
in the right direction, with further implementation of
fiscal austerity measures that were approved in the
summer of 2006. The public deficit should shrink to
6.5 per cent of GDP this year and 4.5 per cent in
2008. Under such a scenario, the Maastricht criteria
might be met in 2010, permitting euro adoption in
2012. Allowing for some fiscal or inflationary slip-
page, 2014 is a realistic target for euro zone member-
ship. Lately the government has declared its intention
to approve a euro introduction plan by mid-2008 and
to join the euro zone between 2010 and 2015.
Dovish atmosphere building up
During 2006, the National Bank of Hungary was
particularly hawkish and raised its base rate from 6 to
8 per cent in order to fight the weak currency and
inflationary risks. At the beginning of March 2007 a
new central bank governor, András Simor, succeeded
Zsigmond Járai. The new head of the NBH is expect-
ed to be more dovish than his predecessor. In line
with lower inflation in the second half of 2007 and
suppressed growth, the central bank should start
cutting interest rates in the third quarter of 2007,
reaching a base rate of 7 per cent by the end of the
year. Improved sentiment towards the forint will
support the Hungarian currency, which will strength-
en to HUF 245 per EUR in late 2007.
 Key economic data
Eastern European Outlook — March 2007

CZECH REPUBLIC
2001 2002 2003 2004 2005 2006(f) 2007(f) 2008(f)
GDP, % 2.5 1.9 3.6 4.2 6.1 6.1 4.8 4.5
Inflation, average, % 4.5 1.4 -0.1 2.6 1.6 2.1 2.8 2.7
Unemployment, % 8.1 7.3 7.8 8.3 7.9 7.7 7.2 6.8
Current account, % of GDP -5.3 -5.5 -6.2 -6.0 -2.1 -4.5 -4.0 -3.8
Public sector financial balance, % of GDP -5.8 -6.8 -6.6 -2.9 -3.6 -3.8 -4.0 -3.5
Public sector debt, % of GDP* 25.1 28.5 30.1 30.7 30.4 30.5 31.2 31.5
EUR/CZK, end of period 31.70 31.50 32.40 30.30 29.00 27.50 27.30 27.00
Key rate, eop 4.75 2.75 2.00 2.50 2.00 2.50 3.00 3.50
5-year government bond, eop 4.70 3.10 3.70 3.40 3.20 3.30 3.80 4.00

ESTONIA
2001 2002 2003 2004 2005 2006(f) 2007(f) 2008 (f)
GDP, % 7.7 8.0 7.1 8.1 10.5 11.4 8.0 7.0
Inflation, average, % 5.6 3.6 1.4 3.0 4.1 4.4 4.0 3.5
Unemployment, % 12.6 10.3 10.0 9.7 7.9 5.9 6.5 7.0
Current account, % of GDP -5.2 -10.6 -11.6 -12.5 -10.5 -13.8 -12.0 -11.0
Public sector financial balance, % of GDP 0.3 1.0 2.4 1.5 1.6 1.9 0.9 0.5
Public sector debt, % of GDP 4.7 5.6 5.7 5.2 4.5 4.0 3.7 3.5
EUR/EEK, end of period 15.60 15.60 15.60 15.60 15.60 15.60 15.60 15.60
3-month interest rate, eop 4.00 3.50 2.60 2.40 2.60 3.90 4.30 4.50

HUNGARY
2001 2002 2003 2004 2005 2006(f) 2007(f) 2008(f)
GDP, % 4.1 4.3 4.1 4.9 4.2 3.9 2.3 2.8
Inflation, average, % 9.1 5.2 4.7 6.8 3.5 4.0 7.0 4.3
Unemployment, % 5.7 5.8 5.9 6.1 7.2 7.5 8.0 7.8
Current account, % of GDP -6.1 -7.0 -8.7 -8.8 -7.4 -7.5 -5.5 -5.0
Public sector financial balance, % of GDP -4.1 -9.0 -7.2 -6.5 -7.8 -9.6 -6.5 -4.5
Public sector debt, % of GDP 52.1 55.6 58.0 59.4 61.7 68.5 72.0 73.0
EUR/HUF, end of period 246.30 235.90 262.20 245.90 252.70 252.30 245.00 240.00
Key rate, eop 9.75 8.50 12.50 9.50 6.00 8.00 7.00 6.50
5-year government bond, eop 7.80 7.10 9.30 8.00 7.10 7.40 7.00 6.20

(f) = forecast

23
Key economic data
Eastern European Outlook — March 2007

LATVIA
2001 2002 2003 2004 2005 2006(f) 2007(f) 2008(f)
GDP, % 8.0 6.5 7.2 8.6 10.6 11.9 9.2 8.2
Inflation, average % 2.5 2.0 2.9 6.2 6.9 6.6 6.5 5.8
Unemployment, % 13.1 12.0 10.6 10.4 8.7 6.9 5.8 5.2
Current acccount, % of GDP -7.6 -6.6 -8.1 -12.9 -12.4 -20.9 -18.0 -15.0
Public sector financial balance, % of GDP -2.1 -2.3 -1.2 -0.9 0.2 -0.3 -0.1 0.2
Public sector debt, % of GDP 13.7 13.2 14.4 14.5 11.9 9.7 9.3 9.0
EUR/LVL, end of period 0.56 0.61 0.67 0.70 0.70 0.70 0.70 0.70
Key rate, eop 3.50 3.50 3.00 3.50 4.00 5.00 6.00 6.25
5-year government bond, eop 8.00 5.50 4.60 4.00 3.20 4.90 5.40 5.70

LITHUANIA
2001 2002 2003 2004 2005 2006(f) 2007(f) 2008 (f)
GDP, % 6.6 6.9 10.3 7.3 7.6 7.5 7.0 6.5
Inflation, average, % 1.6 0.3 -1.1 1.2 2.7 3.8 4.0 3.0
Unemployment, % 17.4 13.8 12.4 11.4 8.3 5.6 5.9 6.1
Current account, % of GDP -4.7 -5.1 -6.8 -7.7 -7.2 -11.0 -10.0 -8.0
Public sector financial balance, % of GDP -2.0 -1.4 -1.2 -1.4 -0.5 -0.5 -0.5 -1.0
Public sector debt, % of GDP 22.9 22.3 21.2 19.4 18.7 18.2 17.0 16.0
EUR/LTL, end of period 3.53 3.45 3.45 3.45 3.45 3.45 3.45 3.45
3-month interest rate, eop 5.30 3.50 2.70 2.60 2.50 3.80 4.50 4.50
5-year government bond, eop 5.80 4.60 3.60 3.00 3.10 3.90 4.60 4.60

POLAND
2001 2002 2003 2004 2005 2006(f) 2007(f) 2008(f)
GDP, % 1.1 1.4 3.8 5.3 3.2 5.8 5.8 5.4
Inflation, average, % 5.3 1.9 0.7 3.6 2.2 1.3 2.3 2.5
Unemployment, % 18.2 19.9 19.6 19.0 17.7 14.0 11.0 10.0
Current account, % of GDP -2.9 -2.6 -2.2 -1.5 -1.4 -2.0 -2.4 -2.6
Public sector budget balance, % of GDP -3.7 -3.2 -4.7 -3.9 -2.5 -2.4 -3.9 -3.5
Public sector debt, % of GDP 36.7 39.8 43.9 41.9 42.0 45.0 46.0 46.0
EUR/PLN, end of period 3.52 4.01 4.72 4.07 3.86 3.90 3.75 3.80
Key rate, eop 11.50 6.75 5.25 6.50 4.50 4.00 4.25 4.50
5-year government bond, eop 9.50 5.50 6.70 6.20 5.00 4.98 5.20 5.30

(f) = forecast

24
 Key economic data
Eastern European Outlook — March 2007

RUSSIA
2001 2002 2003 2004 2005 2006(f) 2007(f) 2008(f)
GDP, % 5.1 4.7 7.3 7.2 6.4 6.7 6.5 6.0
Inflation, average, % 21.6 15.8 13.7 10.8 12.7 9.7 8.5 8.0
Unemployment, % 9.0 8.1 8.6 8.2 7.6 7.2 6.7 6.5
Current account, % of GDP 11.1 8.4 8.2 9.9 10.9 10.0 7.0 4.5
Public sector financial balance, % of GDP 2.7 0.6 1.4 4.9 8.1 7.5 4.0 3.0
Public sector debt, % of GDP 47.6 40.4 29.6 22.4 14.5 9.0 7.5 7.0
USD/RUB, end of period 30.10 31.80 29.50 27.70 28.70 26.30 24.50 24.00
3-month interest rate, eop 18.00 14.50 6.90 6.40 6.50 5.50 6.00 6.50

SLOVAKIA
2001 2002 2003 2004 2005 2006(f) 2007(f) 2008(f)
GDP, % 3.2 4.1 4.2 5.4 6.0 8.3 8.0 6.5
Inflation, average, % 7.2 3.5 8.4 7.5 2.8 4.3 2.5 2.3
Unemployment, ILO, % 19.3 18.7 17.6 18.2 16.3 13.5 12.2 11.0
Current account, % of GDP -8.4 -8.0 -0.8 -3.5 -8.8 -7.9 -4.5 -3.5
Public sector financial balance, % of GDP -6.5 -7.7 -3.7 -3.0 -2.9 -3.4 -3.0 -2.8
Public sector debt, % of GDP 49.2 43.3 42.7 41.6 34.5 34.2 33.5 33.2
EUR/SKK, end of period 42.70 41.50 41.10 38.70 37.80 34.40 32.00 31.50
Key rate, eop 7.75 6.50 6.00 4.00 3.00 4.75 4.25 4.00
5-year government bond, eop 7.70 5.40 5.20 4.00 3.20 4.40 3.90 3.80

UKRAINE
2001 2002 2003 2004 2005 2006(f) 2007(f) 2008 (f)
GDP, % 9.2 5.2 9.6 12.1 2.6 7.0 7.5 8.0
Inflation, average, % 12.0 0.8 5.2 9.0 13.5 9.1 8.5 8.0
Unemployment, % 10.9 9.6 9.1 8.6 7.2 5.5 5.0 4.0
Current account, % of GDP 3.7 7.5 5.8 10.6 3.1 -1.5 -2.0 -3.0
Public sector financial balance, % of GDP -0.3 0.7 -0.2 -3.2 -1.8 -1.0 -1.5 -1.5
Public sector debt, % of GDP 36.5 33.5 29.0 24.7 17.7 15.3 14.0 13.0
USD/UAH, end of period 5.30 5.33 5.33 5.31 5.05 5.05 5.05 5.05
Key rate, eop 12.50 7.00 7.00 9.00 9.50 8.50 8.50 8.00
3-month interest rate, eop 28.30 7.90 23.50 28.00 15.30 12.80 10.00 9.50

(f) = forecast

25
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