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                CEE: Fighting the downturn

April 2020                       April 2020     CEE Macro & Strategy Research
                                                             CEE Quarterly

                     “Your Leading Banking Partner in

                     Central and Eastern Europe

UniCredit Research                 page 2                   See last pages for disclaimer.
April 2020                                                      April 2020                                CEE Macro & Strategy Research
                                                                                                                             CEE Quarterly

                                4   CEE: Fighting the downturn
                               16   CEE Strategy: More weakness before risk appetite returns
                               66   Acronyms and abbreviations used in the CEE Quarterly

                               22   Bulgaria: Economy braces for a deep but short recession
                               26   Croatia: Coping with the impact of lockdown
                               30   Czechia: Shocking times
                               34   Hungary: Pushing boundaries
                               38   Poland: Uncertainties galore
                               42   Romania: Testing times
                               46   Slovakia: COVID-19 shutting down a significant part of the economy
                               48   Slovenia: Growth to be hit by the impact of COVID-19

                                    EU CANDITATES AND OTHER COUNTRIES
                               50   Bosnia and Herzegovina: Deep recession caused by COVID-19 outbreak
                               52   North Macedonia: EU accession talks temporary clouded by COVID-19
                               54   Russia: A perfect storm to test macroeconomic stability
                               58   Serbia: Economic challenges
                               62   Turkey: Recovery to be disrupted by the pandemic

                                     Erik F. Nielsen, Group Chief Economist (UniCredit Bank, London)
                                     +44 207 826-1765, erik.nielsen@unicredit.eu
                                     Dan Bucşa, Chief CEE Economist (UniCredit Bank, London)
                                     +44 207 826-7954, dan.bucsa@unicredit.eu
                                     Florin Andrei, PhD, Senior Economist Romania (UniCredit Bank Romania)
                                     +40 21 200-1377, florin.andrei@unicredit.ro
                                     Artem Arkhipov, Head of Macroeconomic Analysis and Research Russia (UniCredit Russia)
                                     +7 495 258-7258 ext. -7558, artem.arkhipov@unicredit.ru
                                     Gökçe Çelik, Senior CEE Economist (UniCredit Bank, London)
                                     + 44 207 826-6077, gokce.celik@unicredit.eu
  Published on 15 April 2020
                                     Ariel Chernyy, Economist, Macroeconomic Analysis and Research Russia (UniCredit Russia)
                                     +7 495 258-7258 ext. 7562; ariel.chernyy@unicredit.ru
                                     Hrvoje Dolenec, Chief Economist (Zagrebačka banka)
  Erik F. Nielsen                    +385 1 6006-678, hrvoje.dolenec@unicreditgroup.zaba.hr
  Group Chief Economist
  (UniCredit Bank, London)           Dr. Ágnes Halász, Chief Economist, Head of Economics and Strategic Analysis Hungary (UniCredit Hungary)
  120 London Wall                    +36 1 301-1907, agnes.halasz@unicreditgroup.hu
  UK-London                          Ľubomír Koršňák, Chief Economist (UniCredit Bank Czech Republic and Slovakia)
  EC2Y 5ET                           +42 12 4950-2427, lubomir.korsnak@unicreditgroup.sk
                                     Elia Lattuga, Co-Head of Strategy Research (UniCredit Bank, London)
  Imprint:                           +44 207 826-1642, elia.lattuga@unicredit.eu
  UniCredit Bank AG                  Mauro Giorgio Marrano, Senior CEE Economist (UniCredit Bank, Vienna)
  UniCredit Research                 +43 50505-82712, mauro.giorgiomarrano@unicredit.de
  Am Eisbach 4                       Kristofor Pavlov, Chief Economist (UniCredit Bulbank)
  D-80538 Munich                     +359 2 923-2192, kristofor.pavlov@unicreditgroup.bg
  Supplier identification:           Pavel Sobíšek, Chief Economist (UniCredit Bank Czech Republic and Slovakia)
  www.unicreditresearch.eu           +420 955 960-716, pavel.sobisek@unicreditgroup.cz

UniCredit Research                                                  page 3                                                  See last pages for disclaimer.
April 2020                                                                April 2020                                 CEE Macro & Strategy Research
                                                                                                                                        CEE Quarterly

                                            Fighting the downturn
Dan Bucsa,                                  ■   CEE is expected to face the deepest recession of the century in 2020. Exports and imports
Chief CEE Economist
(UniCredit Bank, London)                        will contract sharply as global supply chains crumble. Domestic demand will be hit by rising
+44 207 826-7954                                unemployment, corporate failures and uncertainty.
                                            ■   Support from governments and central banks is unprecedented, with both fiscal and financial
                                                conditions expected to be loosened, in contrast to 2008-10.

                                            ■   The 2021 recovery is unlikely to recoup all losses incurred this year, with employment and
                                                capex lagging the rebound. In addition, rebuilding supply chains could prove cumbersome.

                                            ■   In EU-CEE 1, we expect GDP to fall by 9.4% in 2020 and to grow by 8.5% in 2021.

                                            ■   Russia’s economy could contract by around 5.4% in 2020, with a 3.8% rebound next year.

                                            ■   In Turkey, GDP could fall by approximately 5.6% this year and grow by 6.6% in 2021.

                                            ■   We expect additional rate cuts in Czechia, Poland, Russia, Serbia and Turkey. Only Czechia
                                                and Poland are likely to consider raising rates in 2021.

                                            ■   In 2020, inflation is likely to fall below target in EU-CEE and the Balkans, and to single digits
                                                in Turkey. Base effects, supply shocks and large fiscal impulses will support reflation in 2021.
                                                In Russia, inflation could rise above target in 2020 and fall below 4% in 2021.

                                            ■   Most CEE currencies are undervalued. Long-end local-currency bonds are attractive given
                                                central bank purchases.

                                            ■   Positive potential outcomes of the COVID-19-induced crisis are a stronger civil society, a
                                                reset of voter priorities, leaner bureaucracies and shorter supply chains in Europe.

                                            ■   Negative potential outcomes might be a further democratic backslide, poor EU fund
                                                allotment for 2021-27 and social unrest.

                                            CEE in quarantine…
                                            “We were sure our hospitals were not able to withstand the situation. We had to react.”
                                            Adam Vojtech, Czech Health Minister, quoted in the WSJ

A double hit from domestic                  The small, open economies of CEE are facing a double hit from domestic lockdowns and
lockdowns and collapsing
foreign demand                              collapsing foreign demand. Italy’s decision to go into a national lockdown once cases and
                                            deaths escalated was quickly emulated in EU-CEE but not in the Balkans or Turkey. Russia
                                            was the first country to register COVID-19 cases and one of the first to impose restrictions.
                                            Yet among the countries covered in this report, Russia took the longest to impose localized
                                            and national lockdowns. In contrast, EU-CEE countries moved very quickly, with Slovakia,
                                            Slovenia and Bulgaria standing out. Summarized in the quote from Czech Health Minister
                                            Adam Vojtech, the fear of overwhelmed health-care sectors was stronger than the fear of
                                            economic damage. At the time of writing this CEE Quarterly, only Bosnia-Herzegovina,
                                            Hungary, North Macedonia and Turkey do not have national lockdowns in place.

Lockdowns enforced in CEE                   Lockdowns in EU-CEE led to strong declines in travel and social activities (Charts 1 and 2).
                                            With measures differing in intensity, the situation is not fully comparable across countries.
                                            Data from Google also shows compliance with measures has been falling recently, a sign of
                                            lockdown fatigue.

    EU-CEE comprises Bulgaria, Croatia, Czechia, Hungary, Poland, Romania, Slovakia and Slovenia – all CEE countries that are members of the EU.

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April 2020                                                                             April 2020                                        CEE Macro & Strategy Research
                                                                                                                                                               CEE Quarterly

CHART 1:                                                                                        CHART 2: …BETTER THAN IN COUNTRIES PREPARING TO
SOCIAL DISTANCING MEASURES ENFORCED IN CEE…                                                     EASE RESTRICTIONS

      change in visits and length of stay compared to 3 January - 6 February 2020, %                 change in visits and length of stay compared to 3 January - 6 February 2020, %
         0                                                                                              0
Transit stations


                                                                                                                                                       CZ                      DK
                   -40                                                                                                                         HU           PL
                                                  HU                                                         -30
                             SI          CZ       DE                     DK                                                                                 DE
                   -50                                                                                                    BG                      SK
                                  SK    BH                                                                   -40         RO
                   -60                                                                                                          SI
                                 AT HR BG                                                                                        HR    AT
                                       PL                                                                                TR           BH
                   -70                                                                                       -50
                              RO   MK                                                                                  MK
                   -80              TR
                      -100        -80         -60             -40       -20            0
                                                                                                                -100     -50            0              50            100              150
                                         Retail and recreation venues

                                                                                                                                        Source: Google Mobility, UniCredit Research

Epidemic curves expected to                              Yet lockdowns seem to be working, with the number of deaths growing at a slower pace than
flatten in late April-early May
                                                         in western Europe when accounting for population and even for the number of tests.
                                                         However, epidemic curves are not flattening significantly in any of the CEE countries.
                                                         Adjusted for the number of tests, the number of infected and deceased suggest that the peak
                                                         in daily numbers of victims might be 2-4 weeks away, meaning in late April to mid-May.
                                                         Containing the spread is paramount because health-care systems in CEE generally score
                                                         poorly compared to their EU and OECD peers. While positions in global rankings have
                                                         improved since the global financial crisis, there is still room for improvement. The strains are
                                                         already showing, particularly in Romania, where poor management has led to a high number
                                                         of medical personnel becoming infected and several hospitals being closed or taken under
                                                         military administration. Vital ventilators and protection equipment were in short supply
                                                         throughout the region at the onset of the epidemic, but the situation is improving.

                                                         …drawing unprecedented response…
                                                         “We face a time of trial […], perhaps the most serious in decades. […] We won’t be able to avoid
                                                         this storm completely. […] We have to fight for our economy, our companies and workplaces.”

                                                         Mateusz Morawiecki, Prime Minister of Poland

Authorities have reacted                                 The picture is not entirely bleak. In this unprecedented crisis, authorities reacted quickly and
quickly and continue to
implement measures to
                                                         showed uncharacteristic adaptability. The list of support measures from governments, central
address…                                                 banks and other public entities is growing by the day, with the IMF doing a commendable job
                                                         in tracking all these changes on its website. As has happened around the world, CEE
                                                         governments and central banks have reacted quickly to the looming crisis and have allocated
                                                         unprecedented resources. In the country sections of this publication, we discuss the most
                                                         important measures taken as of 7 April. Much more may be in the pipeline as authorities
                                                         grapple with the fallout from lockdowns. Influenced by the experience of other countries,
                                                         authorities have been quick to adopt best practice insofar as fiscal space allows. Differences
                                                         in firepower, scope and focus are inevitable.

                                                         Throughout CEE, governments have tried to address three stages of the current crisis:

…strains on health-care                                  1.    The immediate strain on health-care systems. Funding was increased, public tenders
                                                               sped up to acquire the necessary equipment, health-care personnel received one-off
                                                               payments and promises of wage increases, especially in countries, such as Hungary,
                                                               that have been less generous in the past.

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April 2020                                               April 2020                           CEE Macro & Strategy Research
                                                                                                               CEE Quarterly

…strains on companies and      2.   The strain on companies and employees. All governments tried to avoid a large wave
                                    of layoffs, albeit with differing success. Initially, authorities promised to cover the cost of
                                    workers on furlough, with support ranging from 35% in Hungary to 75% in Romania. The
                                    reaction was insufficient to prevent a large initial wave of unemployment for two main
                                    reasons. First, access to financial support was cumbersome, requiring complicated
                                    paperwork. By the time the Romanian government moved to ease access to funding, 155,000
                                    people had been laid off and almost 800,000 had been put on furlough. As a result, many
                                    governments, including that of Romania, simplified procedures and allowed companies to
                                    apply for help online. Second, many companies believed that long restrictions would fatally
                                    undermine their activity and closed their businesses. Again, governments moved to prevent a
                                    wave of bankruptcies. The largest and most meaningful reaction to support employers came
                                    from Poland, which pledged 6.7% of GDP to companies that try to avert closures and layoffs,
                                    on top of shouldering 70% of the cost of furlough. Up to 4% of GDP may not be reimbursed
                                    by the most resilient companies. Other measures include zero-cost funding for companies
                                    (Hungary), funding with interest covered by the government (Romania), and funding at
                                    subsidized cost (Russia and Turkey). Some countries included guaranteeing jobs until at least
                                    the end of the year as a condition for their liquidity support.

                                    In addition, governments allowed companies and households to postpone some tax
                                    payments, including those that were overdue. Banks agreed to moratoriums on loan
                                    repayments, especially for SMEs and mortgage borrowers. In Hungary and Romania,
                                    authorities intervened to impose moratoriums until the end of the year. The danger is
                                    excessive populism, with some politicians suggesting broader tax and payment holidays
                                    that do not discriminate between those who need help and those able to weather the
                                    crisis without public support.

… the future recovery.
                               3.   The future recovery. The amount of state guarantees and credit available from
                                    development banks and state agencies exceeds 5% of GDP in all countries and goes
                                    above 10% of GDP in central Europe, with Hungary standing out. Central banks added to
                                    their contributions by cutting interest rates. By the time they are done cutting, the cost of
                                    central bank funding will be the lowest on record.

Immediate support is between   It is too early to judge the success of all these measures. When looking at immediate support
1% and 8% of GDP               (for health care, unemployment and companies in distress), packages amount to between 1%
                               and 8% of GDP, the rest coming in the form of guarantees and support measures that could
                               be used when the economy starts to recover. Poland stands out, followed by other countries
                               with large fiscal space, such as Czechia and Bulgaria. Despite starting with the worst fiscal
                               position in EU-CEE, Romania managed to put forward an immediate support package that is
                               larger and more comprehensive than Hungary’s. Slovenia, Slovakia and Croatia all pledged
                               urgent help in excess of 5% of GDP. Turkey’s package is over reliant on the CBRT, whose
                               toolbox continues to expand rapidly. Russia is the outlier, where a government with
                               unparalleled firepower has been slow to react.

                               Hungary has the most impressive package of guarantees and support measures once the
Large loan guarantee
                               worst is over and economies start to look forward to the recovery. It also has a tried and
                               tested system of funneling cheap funding to the private sector through its Funding for Growth
                               Schemes. Trillions of HUF have been allocated to investment in infrastructure, tourism and
                               business development and the take-up could be large, provided the economy weathers the
                               current downturn and foreign demand recovers.

… and cheap funding for the    Elsewhere, lending to companies could increase because costs of funding are very low
recovery stage                 (Bulgaria, Croatia, Czechia, Poland, Slovakia and Slovenia) or are falling (Romania, Russia,
                               Serbia and Turkey).

UniCredit Research                                          page 6                                            See last pages for disclaimer.
April 2020                                                                     April 2020                                     CEE Macro & Strategy Research
                                                                                                                                                CEE Quarterly

2020 budget deficits above 5%                 In 2020, we expect budget deficits to balloon to more than 5% of GDP in most CEE countries
of GDP in most countries…
                                              (Chart 3), regardless of the commitments some governments are still making to fiscal
                                              restraint. This translates into the largest fiscal impulses on record in Bulgaria, Czechia,
                                              Croatia, Poland, Slovenia, Slovakia and Russia, even accounting for the decline in revenues.
                                              Romania and Turkey, whose structural budget deficits exceeded 4% of GDP in 2019, have
                                              the least fiscal space and will thus have less room to spend. Budget deficits of 7% of GDP or
                                              more may be very difficult to finance outside the eurozone. Central banks could monetize
                                              most of the fiscal deficit, but we expect the NBR to avoid this solution. To keep the deficit in
                                              check, the Romanian government will have to cut other types of spending. The 40% pension
                                              increase that spooked investors will probably be replaced with a much smaller rise. But this is
                                              not all: at least half of planned public investment could be redirected to social spending and
                                              the public wage bill could be cut.

…with 2021 deficits above 3% of               Throughout CEE, governments are unlikely to withdraw support completely in 2021 due to high
GDP in many countries
                                              unemployment, a possible return of the epidemic, the need to support the recovery or a combination
                                              of these factors. Thus, budget deficits could remain above 3% of GDP in many countries.

                                              Will all this matter for ratings? In our opinion, it should not. The countries facing the biggest
No rating action expected                     risk of downgrades, Romania and Turkey, will see public debt remaining below 45% of GDP
in 2020
                                              at the peak, safely in investment-grade territory (Chart 4). Adjusted for the effect of COVID-19
                                              (higher expenses, lower revenues), this year’s budget deficit is likely to be less than 4% of
                                              GDP in Romania. In 2021, the budget deficit could be around 3.7% of GDP. In Turkey, the
                                              current rating takes large budget deficits in the coming years into account.

CHART 3: LARGE BUDGET DEFICITS IN 2020…                                               CHART 4: …LEADING TO A TEMPORARY INCREASE IN DEBT

   budget balance (% of GDP)              2019E    2020F     2021F                         public debt (% of GDP)                2019E     2020F     2021F
    2.0                                                                                   100

   -2.0                                                                                    70
   -4.0                                                                                    50

   -8.0                                                                                    20
             SK   RS   TR      BG   RO   HR   CZ   SI   PL   HU      RU   BH
                                                                                                RU    BG     BH     CZ   TR    RO   PL    RS    SK     HU      SI    HR

                                                                                 Source: Eurostat, national statistical offices, ministries of finance, UniCredit Research

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April 2020                                                                     April 2020                                   CEE Macro & Strategy Research
                                                                                                                                                 CEE Quarterly

                                               …with an eye to loosening restrictions…
                                               “The virus makes the timeline.”
                                               Dr. Anthony Fauci, director of the National Institute of Allergy and Infectious Diseases, US

Most restrictions to be                        All CEE countries are looking at the prospect of lifting lockdown measures, weighing the risk
eased in 3Q20
                                               of high numbers of infected and strained health-care sectors against that of damaging the
                                               economy irreversibly. The timeline remains uncertain, as no CEE country can affords a
                                               re-acceleration of infections and deaths. Throughout CEE, states of emergency are likely to
                                               extend into the summer, allowing authorities to reverse some decisions, be they to relax or
                                               tighten restrictions, in response to conditions. We expect governments to start easing
                                               restrictions this quarter, with most being removed in 3Q20.

                                               A group of doctors have set forth the following four conditions for gradually reopening the
                                               economy 2:

                                               1.    Contain the spread

                                               2.    Improve the capacity to test, identify and control the spread
                                               3.    Remove remaining restrictions when a vaccine becomes available

                                               4.    Invest in preparing for the next pandemic
Differentiating factors in
removing restrictions                          With a vaccine possibly more than a year away, some restrictions could remain in place for a
                                               long time. Lifting lockdowns and easing controls in CEE will depend on four traits, which vary
                                               across the region.

                                               1.    The strain on health-care systems. Some countries, such as Turkey, Romania and
                                                     Serbia, may have to impose longer restrictions to ease the burden on intensive care units
                                                     and reduce the number of deaths.

                                               2.    The handling of the disease. The experience of countries like South Korea, Taiwan and
                                                     Singapore shows that, in order to flatten epidemic curves, quantitative and qualitative
                                                     information about the epidemic is paramount. In CEE, the Baltics, Czechia and Slovenia
                                                     have been the most assiduous testers and may have a better picture of the spread and
                                                     intensity of the epidemic. However, in most CEE countries the number of tests is still well
                                                     below 1% of the population and there is probably insufficient information to draw solid
                                                     conclusions about geographical spread, the proportion of those infected (especially in
                                                     urban areas), shape of the epidemic curve and potential number of victims.

                                               3.    The intensity of current restrictions. Stronger restrictions now could allow for broader
                                                     easing in the near future. While most CEE countries imposed strict social distancing
                                                     measures, others opted for partial restrictions. Turkey quarantined only large cities.
                                                     Elsewhere, only the young and the elderly faced restrictions. Serbia curbed freedom of
                                                     movements only at weekends and between 5PM and 5AM. In contrast, Russia’s total
                                                     lockdown may not be needed if travel between regions is restricted further. Infections are
                                                     rising at much faster pace in Moscow and large cities than in remote republics and
                                                     territories. Some governors contested the decision to impose a month-long “holiday” on
                                                     the whole country and restrictions could be eased in regions with few cases.

                                               4.    Conformity with rules. Restrictions seem to be being enforced well. Once they are
                                                     relaxed, the population will still have to comply with social distancing rules in public
                                                     spaces, be it at work, while commuting or when shopping. Culture and lockdown fatigue
                                                     may well play a role. Countries where social norms and rules are easily ignored risk a
                                                     second rise in infections before 4Q20.

    Gottlieb, S., C. Rivers, M. McClellan, L. Silvis, C. Watson, “National Coronavirus Response: A Road Map to Reopening”, American Enterprise Institute, 30 March 2020

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April 2020                                                                   April 2020                                   CEE Macro & Strategy Research
                                                                                                                                        CEE Quarterly

                                              …to limit the recession and restart growth.
SMEs need lockdowns to ease                   Loosening restrictions is paramount to avoiding a longer slump after the inevitable recession
this quarter
                                              in 2Q20. The EU is calling for a coordinated removal of restrictions. Most SMEs in CEE
                                              estimate they can survive for 2-3 months before having to shut down activity. This means that
                                              activity needs to resume, at least partially, in late May or June at the latest. Country evidence
                                              also suggests that most companies seeking public support had no prior financial problems,
                                              and boasted a good track record of tax payments and loan repayments. This is not a surprise.
                                              Most companies applying for public support come from manufacturing and the hospitality
                                              industry, two sectors that were thriving before the pandemic struck, but are now the hardest
                                              hit by lockdowns.

                                              In many cases, companies in manufacturing that are asking for public support are exporters whose
                                              supply chains have broken down due to global restrictions. The globalization of manufacturing
                                              came with a growing efficiency of supply chains. Just-in-time production methods increased
                                              efficiency but reduced the need for inventories and storage capacity. As a result, production may
                                              encounter repeated bottlenecks when it resumes, much more so than if this crisis had happened a
                                              decade ago. Thus, a rebound in CEE very much depends on how the global economy, especially
                                              that of the eurozone, copes with the crisis and how quickly it rebounds.

                                              We expect global GDP to fall by 6% this year, with a very deep trough in 2Q20. The
Sharp fall in global and
eurozone GDP…                                 eurozone’s economy could contract by 21.5% qoq in 2Q20 and by 13% in the entire year. Our
                                              global scenario assumes that most restrictions in western Europe and the US will be lifted in
                                              3Q20, leading to a V-shaped recovery of the global economy 3. However, it will take until 2022
                                              for economic activity to return to pre-crisis levels.

                                              Given our global outlook, we expect CEE GDP to fall by around 7% in 2020, but we see
…to drive CEE GDP down by                     differentiation among countries (Chart 5). We expect the smallest contraction in Russia, at
around 6.4% in 2020.
                                              around 5.4%, due to at least five reasons. First, the credit impulse may be resilient, helped by
                                              pent-up demand and the CBR’s decision to subsidize lending to companies. Second, imports
                                              are likely to match the decline in exports, limiting the negative impact on GDP growth. Third,
                                              the planned referendum to change the Constitution and allow President Vladimir Putin two
                                              more terms could loosen the purse strings of the Russian authorities and boost household
                                              income in the hope of a good result. Fourth, the proportion of workers employed by the state
Russia and Turkey to contract                 or state-owned companies is higher than in EU-CEE and, thus, unemployment might increase
by more than 5%, but less than                less in Russia than in EU-CEE. Finally, Russia’s enormous landmass means that the
                                              lockdown will never be as tight as in some other CEE countries. That said, risks are skewed
                                              to the downside because the Russian government has failed so far to match the measures
                                              taken elsewhere in CEE. If this inaction continues and/or the epidemic is not contained, the
                                              contraction could be deeper and the recovery more muted.

                                              Turkey’s economy could shrink by around 5.6% this year. When judged against potential,
                                              however, the decline will be comparable to that in less open EU-CEE countries. Both the
                                              government and the CBRT will try to help as much as possible an economy that is yet to recover
                                              fully from the 2018 recession. Experience shows that attempts to boost lending significantly can
                                              end up in financial turbulence and Turkey’s recovery from 3Q20 onwards could be choppy.

… where GDP could fall by                     Given our eurozone outlook, EU-CEE economies may shrink by around 9.4% in 2020, even if
around 9.4% in 2020.                          GDP bottoms out in 2Q20. More openness could lead to deeper troughs in Czechia, Hungary,
                                              Slovakia and Slovenia, where GDP could contract by more than 20% qoq due the collapse in trade
                                              and investment. The adjustment will be severe in countries dependent on tourism, with Croatia
                                              standing out. Hungary, Serbia and Turkey would also be affected more than the rest of CEE.

    For details, please see the UniCredit Economics Chartbook - The mother of all recessions has arrived, published on 2 April 2020.

UniCredit Research                                                               page 9                                                See last pages for disclaimer.
April 2020                                                                               April 2020                                          CEE Macro & Strategy Research
                                                                                                                                                                    CEE Quarterly

2021 recovery will not offset                        In 2021, the recovery will be impressive, but most countries will fail to recoup the losses
2020 losses in most countries
                                                     registered in 2020. Throughout CEE, the upturn may be slowed by the delayed rebound in the
                                                     labor market and investment. Labor-market conditions loosened abruptly in March, as
                                                     signaled by PMIs. Unemployment is likely to rise in the coming months, either because some
                                                     companies do not have access to public support or do not want to access it. In addition, some
                                                     companies will delay redundancies until after government facilities expire. We expect
                                                     unemployment rates to rise more than during the global financial crisis and to start declining
                                                     already before the end of the year. We do not expect unemployment to have returned to
                                                     pre-COVID-19 levels by the end of 2021.

CHART 5: SHARP ECONOMIC CONTRACTION IN 2020…                                                    CHART 6: …FOLLOWED BY A RECOVERY IN 2021

   yoy (%),          Private consumption   Public consumption   Fixed investment                      yoy (%),         Private consumption    Public consumption      Fixed investment
   pp                Net exports           Inventories, error   GDP                                   pp               Net exports            Inventories, error      GDP
    Russia                                                                                            Russia
    Turkey                                                                                            Turkey
    Serbia                                                                                            Serbia
   Bulgaria                                                                                          Bulgaria
    Poland                                                                                            Poland
  Slovenia                                                                                           Slovenia
  Hungary                                                                                            Hungary
             -15.0                 -10.0          -5.0          0.0                5.0
                                                                                                                -5.0             0.0               5.0                10.0               15.0

                                                                                                                       Source: national statistical offices, Eurostat, UniCredit Research

Labor market conditions to                           Labor market conditions will be altered by significant migrant flows. Poland and, to a lesser
                                                     extent, Czechia and Slovakia, saw a wave of economic immigrants leaving before full
                                                     lockdowns were implemented. The reasons being job losses, lack of health-care insurance or
                                                     just the desire to return to their families. The Polish government estimates that 100,000
                                                     Ukrainians left Poland in less than a month, although the number is probably much higher.
                                                     Besides the reasons mentioned above, some Ukrainians failed to renew their temporary work
                                                     permits, despite the Polish government easing access conditions when it realized the
                                                     problem. At the same time, Romania and the western Balkans experienced a wave of workers
                                                     returning from western Europe, especially from Italy, Spain and Portugal. The Romanian
                                                     press estimates that more than 300,000 people have returned from western Europe since the
                                                     outbreak of the pandemic.

…amid diverging migration                            The impact of diverging patterns of migration could be significant because immigrants that
                                                     leave affect some of the sectors that are not yet shut down, such as agriculture and
                                                     construction. Most returning emigrants are likely to leave again once restrictions ease. Their
                                                     main contribution to their home countries will be a large amount of remittances, of which cash
                                                     transfers will show up in the balance of payments. In countries like Bosnia-Herzegovina,
                                                     Romania and Serbia, as this money is spent it will alleviate some of the pressure on the
                                                     currency in the next couple of quarters and cover some of the widening C/A deficits.

Biggest slump in wage bills on                       Lower employment and wage losses due to workers being furloughed and falling working
record to weigh on consumption
                                                     hours will shrink economy-wide wage bills throughout CEE for the first time since the global
                                                     financial crisis. Like for GDP, the decline is likely to be sharper than in 2008-10. The impact
                                                     on private consumption will only be partly mitigated by government support. If unemployment
                                                     lags the business cycle, as it usually does, private consumption could weigh on annual GDP
                                                     growth until 2Q21.

UniCredit Research                                                                         page 10                                                                 See last pages for disclaimer.
April 2020                                               April 2020                          CEE Macro & Strategy Research
                                                                                                             CEE Quarterly

Investment – the hardest-hit    Among domestic demand components, investment could be the hardest hit. It is very likely
component of domestic demand
                                that inventories have and will be sharply run down because of the deterioration in supply
                                chains. Most capex will be on hold until companies are certain that their businesses have
                                recovered. This is also true for FDI projects, especially those in the manufacturing of durable
                                goods, such as cars and electronics. Companies face cash shortages that will be accentuated
                                by the prevalence of trade credit. In the Balkans (both within and outside the EU), trade credit
                                exceeds bank loans. As a result, it will be very difficult to prevent liquidity issues or even
                                solvency risks, even if state-guaranteed loans are taken up in large amounts.

                                The worst affected building projects may be those for retail and office space, with residential
                                properties affected where prices have increased strongly. The most stretched markets are
                                Prague and Budapest, followed at a significant distance by the large Polish cities. This leaves
                                governments as the main driver of investment through infrastructure projects. The EU has
                                bundled the remaining structural and investment funds into the Coronavirus Response
                                Investment Initiative (CRII), which allows countries to spend the money with little
                                conditionality. However, a large part of the funds are likely to be used to cover current health-
                                care expenditure and employment support, rather than investment projects. With budget
                                deficits stretched, most countries will not have significant funds for infrastructure investment.
                                The exceptions are Hungary, Poland, Serbia and Russia, the latter only if the government
                                speeds up the implementation of national projects. While Bulgaria and Czechia have the fiscal
                                space for large-scale public investment, there seems to be little focus on such projects.

                                Insufficient spending – both private and public – remains a risk, despite central banks
                                stretching their mandates to an unprecedented extent to support economies. Their recent
                                action can be summarized as:

                                1.   liquidity support for banks through repos, swaps and lower reserve requirements;
Five main instruments used by
central banks                   2.   regulatory lenience to allow for debt moratoriums and the use of capital buffers;

                                3.   support for government issuance through secondary market purchases;

                                4.   rate cuts to reduce the cost of funding once moratoriums are over and/or lending picks
                                     up; and

                                5.   indirect support for lending to the private sector through guarantee and lending schemes.

Rate cuts to continue in        The latest range of measures is presented in the individual country sections of this report and
Czechia, Poland, Serbia,        in the EEMEA Country Note - Central banking in CEE: All in. We expect central banks in
Russia and Turkey
                                Czechia, Poland, Serbia, Russia and Turkey to cut rates further (Chart 7). Except for Czechia
                                and Turkey, the cost of funding is likely to fall to all-time lows. The NBH and the NBR are
                                likely to ease liquidity conditions opportunistically when the pressure on their currencies
                                subsides. The mandate to ensure currency stability is now widespread, albeit surprising in
FX stability mandate for most   many cases. We agree with central banks that depreciation will not ease monetary conditions
CEE central banks
                                at this stage due to supply disruptions affecting exports. The chosen solution is to split the
                                market in two, with the local cost of funding being significantly lower than the offshore one.
                                This can be done through FX interventions in Romania, Russia, Serbia and, potentially,
                                Czechia, by providing funds for lending at below-market interest rates (Hungary, Russia and
                                Turkey) and by imposing soft capital controls (Turkey). In Romania, Serbia and Turkey, moral
                                suasion will also play a role in stabilizing exchange rates.

                                Even when accounting for the unusual attention paid to currencies, financial conditions will
                                remain much looser than during the global financial crisis. This will complement loose fiscal
                                policy in supporting the economic recovery.

UniCredit Research                                          page 11                                         See last pages for disclaimer.
April 2020                                                            April 2020                                         CEE Macro & Strategy Research
                                                                                                                                               CEE Quarterly

Falling inflation in 2020,                   A combination of supply and demand shocks is expected to send inflation below targets in
followed by rebound next year…
                                             EU-CEE and in Serbia, and to single digits in Turkey (Chart 8). In Russia, these shocks will
                                             dampen the FX pass-through, allowing inflation not to diverge significantly from target. In
                                             2021, supply shocks and base effects will turn inflationary in EU-CEE, where inflation is
                                             expected to return above target. Substituting cheaper migrant labor with local workers could
                                             add a supplementary inflationary shock in Poland, Czechia and Slovakia. Even if inflation
…with opposite dynamics in                   rebounds slightly in Turkey, domestic demand pressure will remain limited. Weak domestic
Russia.                                      demand pressure could send inflation back below target in Russia. As a result, we see 2020
                                             rate cuts being partly reversed only in Czechia and Poland.

CHART 7: INTEREST RATES WILL REMAIN LOW…                                     CHART 8: …DESPITE REFLATION IN 2021

         policy rates, %         2019   2020F     2021F                            annual inflation (eop, %)        2019E        2020F   2021F      Inflation target
  15.0                                                                            12

  12.0                                                                            10



             PL            CZ   HU      RS       RO       RU     TR
                                                                                        HR     BH      SI      RS   SK      HU     PL    CZ    RO     BG     RU        TR

                                                                                                      Source: statistical offices, central banks, UniCredit Research

                                             Outlook for markets: attractive valuation

                                             While our detailed views can be found in the individual country sections, we highlight here the
                                             main opinions on currencies, rates and credit.

                                             Except for the RON and the RSD, CEE currencies are undervalued and could strengthen
Most CEE currencies are
                                             once risk appetite rebounds. Not all recent depreciation may be reversed, since trade
                                             balances will deteriorate across CEE and FDI will fall. This leaves EU funds as the main
                                             source of stable capital flows. In Romania and Serbia, where extended basic balances are
                                             negative or close to zero, central banks have sufficient reserves and market influence to
                                             defend their currencies, even in risk-off episodes.

                                             Liquidity provisions by core central banks combined with currency undervaluation and central
Central bank bond purchases                  bank purchases in CEE make local-currency bonds attractive. In CEE, most central-bank
in CEE are not QE
                                             bond purchases are sterilized and are therefore not used to inject liquidity. They serve the
                                             purpose of providing a buyer of last resort. This is very important to support issuance and
                                             ensure that bond investors can access cash when facing redemptions.

                                             In EU-CEE, we like all long-end bonds. Although the CNB has not announced bond
Long-end local currency bonds
look attractive…
                                             purchases yet, the curve may flatten due to demand from local investors and risk-averse real-
                                             money funds from the eurozone. In the short term, we prefer ROMGBs because of the implied
                                             FX hedge offered by the NBR. While Romania is facing three rating updates in 2Q20, rating
…with ROMGBs the top pick in                 agencies may stay on hold to gauge the impact of the crisis on budget execution. POLGBs
the short term…                              offer the right balance between risk and return, in our view, although the NBP is notably the
                                             only independent central bank in CEE that has not announced support for its currency.

UniCredit Research                                                      page 12                                                               See last pages for disclaimer.
April 2020                                                                April 2020                        CEE Macro & Strategy Research
                                                                                                                             CEE Quarterly

…and OFZ in the long term.                   Longer term, we like OFZ for the convergence story that is likely to be only temporarily

Short-term rates not fully                   In the rates space, the NBH’s decision to give up using FX swaps suggests paying short-term
pricing in future central bank               rates in Hungary, at least as long as EUR-HUF remains above 350. We would receive
                                             short-term rates in Czechia and Poland in expectation of further easing.

                                             TURKGBs will benefit from CBRT support, but a vulnerable currency leaves the curve (and
                                             especially its short end) prone to sudden corrections.

                                             Credit is generally cheaper than local-currency bonds in CEE. We continue to like ROMANI
                                             EUR bonds, which remain cheaper than ROMGBs. Even though the NBR is not purchasing
ROMANI EUR and RUSSIA USD                    EUR bonds, we do not expect ROMANI-ROMGB spreads to widen for long, with EUR bond
the top picks in the credit                  yields tightening with a delay to local-currency bond yields. RUSSIA USD bonds continue to
                                             trade outside the sovereign rating and outside OFZ, without bearing the latter’s FX risk. .

                                             Once risk appetite recovers globally, which may not happen until late 2Q20, we expect all
                                             curves to flatten under the weight of global liquidity.

                                             Fallout from the pandemic
Positive potential outcomes                  While it is too early to assess the impact of the pandemic on the economy, society and politics
                                             of CEE, we highlight four positive and three negative potential outcomes.

                                             What to look forward to:

                                             1. The strengthening of civil society in countries where it played a role in supporting the
                                                health-care system at a hard time for public administration and state institutions. This may
                                                change the way people interact with the government and markets. In the words of Samuel
                                                Bowles and Wendy Carlin 4, “the COVID-19 pandemic […] may overturn that anachronistic
                                                one-dimensional menu [the government-versus-markets continuum of policy alternatives] by
                                                including approaches drawing on social values going beyond compliance and material gain.”

                                             2. A potential change in voter priorities if the middle class gets more involved in the electoral
                                                process. One such priority is better health care. The main reason for the current sorry state of
                                                health-care provision is a lack of political interest, emigration, poor management and
                                                corruption. The first reason is the most important and all others are influenced by it. Another
                                                priority may be better support for employees and companies in need. It is hard to believe that
                                                governments will be able to withdraw all the measures on display at the moment, with some
                                                politicians arguing for more support for the private sector. However, this clashes with the large
                                                safety net provided to pensioners, the most active category of voters across the region. If
                                                governments try to pursue both goals, they might have to increase taxation.

                                             3. A leaner bureaucracy. It is unlikely that governments will be able to re-introduce the
                                                paperwork that has been substituted with online access to public services. This means
                                                that some public employees may lose their jobs. It also means that governments will have
                                                to further develop their IT capacities to manage information, receive tax payments and
                                                distribute public services.

                                             4. Shorter supply chains for European manufacturers, triggering more investment in CEE.
                                                The pandemic could further undermine globalization, with western European companies
                                                likely to move their supply chains closer to home or, at least, to create an alternative to
                                                Asian suppliers. CEE may benefit once more from this move back to Europe. Fresh from
                                                their struggle to find workers in EU-CEE, western European companies could turn towards
                                                the western Balkans and former Soviet republics. The main issues there are poor-quality
                                                institutions and a lack of economic predictability. Both can be addressed, especially in
                                                countries that are also candidates for EU membership.

    “The coming battle for the COVID-19 narrative”, VOX, 10 April 2020.

UniCredit Research                                                          page 13                                        See last pages for disclaimer.
April 2020                                                                 April 2020                     CEE Macro & Strategy Research
                                                                                                                           CEE Quarterly

Potential negative outcomes                  What to fear:

                                             1.   A further democratic backslide. Many governments implemented states of emergency
                                                  to simplify decision making. While the state of emergency implies a limitation of civil
                                                  rights, in some countries the decisions have gone further. In Hungary, Prime Minister
                                                  Viktor Orbán has received extraordinary powers from parliament, allowing him to govern
                                                  by decree. The only institution able to question his decisions is the Constitutional Court
                                                  (CC), which is packed with Orbán loyalists. Mr. Orbán has used these powers in matters
                                                  unrelated to the COVID-19 crisis, including to further curtail freedom of the press. An
                                                  attempt to reduce the powers of local administration in favor of central government was
                                                  withdrawn amid a public backlash. Parliament failed to set conditions that could revoke
                                                  Mr. Orbán’s powers. The move has been deemed a democratic backslide by European
                                                  institutions and thirteen members of the European Popular Party (EPP) demanded that
                                                  Fidesz, Mr. Orbán’s party, be excluded from its ranks.

                                                  In Poland, the parliamentary majority led by Law and Justice (PiS) has decided to hold
                                                  presidential elections on 10 May through a postal voting system that has never been
                                                  used before. Moreover, elections will go on as planned despite the campaign having
                                                  been suspended due to the lockdown. This benefits the incumbent, Andrzej Duda, who is
                                                  supported by the PiS. Mr. Duda receives much more media coverage than his
                                                  competitors because of his involvement in the official response to the crisis.

                                                  While questions about democratic backsliding will remain for as long as states of
                                                  emergencies are enforced, it seems that from the point of view of voters, the economic
                                                  outcome will be more important than defending political and personal freedoms. In the
                                                  words of Francis Fukuyama 5, “The major dividing line in effective crisis response will not
                                                  place autocracies on one side and democracies on the other. […] The crucial determinant
                                                  in performance will not be the type of regime, but the state’s capacity and, above all, trust
                                                  in government.” Mr. Orbán remains very popular in Hungary, while Mr. Duda could win
                                                  re-election in the first round of voting. Both base their popularity on the strong economic
                                                  track record of their respective parties. In Hungary and Poland, as in Russia, Serbia and
The EU has to prevent further                     Turkey, this crisis will offer elected leaders an opportunity to strengthen their grip on
democratic slippages in
                                                  power at the expense of personal freedoms. In Hungary and Poland’s case, the
Hungary and Poland
                                                  backsliding can only be averted by a stronger reaction from the EU and a more active
                                                  use of the European Court of Justice.

                                             2.    A worse-than-expected outcome in EU budget negotiations for 2021-27. The
                                                   decision of some EU-CEE countries, especially Hungary, to delay negotiations for the
EU-CEE will be the main loser                      next EU budget could come to haunt them. Costs related to the COVID-19 crisis will add
in EU budget negotiations
                                                   to criteria that favor Southern Europe over EU-CEE (alongside youth unemployment,
                                                   number of migrants and evolution of per-capita GDP). Unless the EU decides to top up
                                                   the EU budget allotment (unlikely at this stage), EU-CEE will see its share of funding
                                                   crowded out further and annual losses could exceed 1% of GDP for the Visegrad four
                                                   and the Baltics. Opposition to a deal would leave the EU on a temporary budget
                                                   framework with limited transfers. This would be even more detrimental to CEE, especially
                                                   in 2021-22, when economies would need support to rebound from the 2020 recession.

                                             Social unrest. If lockdowns last for longer than anticipated and the economic damage rises,
                                             CEE could be confronted with a wave of social unrest. Unfortunately, the press is fueling
                                             discontent in many countries. Thus, it is paramount that governments come up with a plan of
                                             re-opening the economy that is credible, well communicated and comes with appropriate
                                             measures to avoid a new rise in infections.

    “The Thing That Determines a Country’s Resistance to the Coronavirus”, The Atlantic, 30 March 2020

UniCredit Research                                                            page 14                                     See last pages for disclaimer.
April 2020                                                                       April 2020                                                  CEE Macro & Strategy Research
                                                                                                                                                               CEE Quarterly


                                                                                                                                                                  Exchange rate
                         GDP growth, %                       CPI (Avg), %                          Policy rate*                 10Y bond yield (EoP), %            (LC vs. USD)
                      2019      2020F       2021F         2019   2020F       2021F         2019         2020F       2021F        2019       2020F    2021F     2019     2020F      2021F
 Eurozone              1.2       -13.0          10.0       1.2        0.3      1.2         -0.50        -0.50       -0.50                                      1.12       1.14        1.18
   Germany             0.6*       -10*          10*        1.4        0.5      1.6                                               -0.19       -0.40   -0.10
   France              1.3       -13.8          11.6       1.1        0.4      1.0
   Italy               0.3       -15.0           9.0       0.6        -0.4     0.8                                                1.41       1.85     1.90
 UK                    1.4       -10.5           9.8       1.8        0.9      1.6         0.75          0.10        0.10                                      1.32       1.30        1.35
 USA                   2.3       -10.8          11.8       1.8        1.2      1.9         1.75          0.25        0.25         1.92       1.15     1.95
 Oil price, USD/bb                                                                                                                                               64         41          47

*Non-wda figures. Adjusted for working days: 0..6% (2019), -10.4% (2020) and 10% (2021): **Deposit rate for ECB                                  Source: Bloomberg, UniCredit Research


 Real GDP                                                   CPI                                                                    C/A balance
 (% change)          2018     2019   2020F      2021F       (% change)         2018          2019        2020F        2021F        (% GDP)            2018     2019      2020F      2021F
 CEE-EU               4.4      3.7       -9.3      8.5      CEE-EU               1.9           3.4          2.0         2.9        CEE-EU              -0.9     -0.4        -2.5       -1.0
   Bulgaria           3.1      3.4       -7.8      7.0       Bulgaria            2.7           3.8          3.2         3.0          Bulgaria           1.4      4.0        2.2         2.8
   Czechia            2.8      2.4   -11.0         8.4       Czechia             2.0           3.2          2.2         2.0          Czechia            0.4     -0.4        -3.0       -1.6
   Hungary            5.1      4.9       -9.3      9.9       Hungary             2.7           4.0          1.6         3.6          Hungary            0.0     -0.9        -2.9       -1.2
   Poland             5.2      4.2       -8.1      7.5       Poland              1.1           3.4          2.1         3.1          Poland            -1.0      0.5        -2.1       -0.6
   Romania            4.4      4.1       -9.4      9.8       Romania             3.3           4.0          2.4         3.5          Romania           -4.6     -5.0        -5.2       -3.9
   Croatia            2.7      2.9   -10.5         6.9      Croatia              0.8           1.4          0.6         2.0        Croatia              1.9      2.9        -6.0        0.7
 Russia               2.3      1.3       -5.4      3.8      Russia               4.3           3.0          4.3         3.5        Russia               6.8      4.2        2.1         1.2
 Serbia               4.4      4.2       -7.0      8.4      Serbia               2.0           1.8          1.3         2.2        Serbia              -4.9     -6.9        -6.5       -6.4
 Turkey               2.8      0.9       -5.6      6.6      Turkey              20.3          11.8          7.9         9.6        Turkey              -2.7      1.2        -0.3       -0.1

 Extended basic                                             External debt                                                          General gov’t
 balance (% GDP)     2018     2019   2020F      2021F       (% GDP)            2018          2019        2020F        2021F        balance (% GDP)    2018     2019      2020F      2021F
 CEE-EU               2.5      2.8        0.8      1.9      CEE-EU              68.7          65.0         69.7        63.2        CEE-EU              -0.6     -1.2        -5.5       -2.9
   Bulgaria           3.6      6.5        5.0      5.5       Bulgaria           59.1          56.2         59.2        54.7          Bulgaria           1.8      1.1        -6.2       -2.9
   Czechia            1.6      1.2       -1.6      0.4       Czechia            82.8          77.6         85.3        80.0          Czechia            1.1      0.0        -5.5       -4.0
   Hungary            4.3      2.5        2.7      2.5       Hungary            81.1          73.9         79.1        68.6          Hungary           -2.1     -2.0        -4.3       -1.5
   Poland             3.6      4.4        2.0      2.4       Poland             63.4          59.2         61.2        53.7          Poland            -0.2     -0.7        -4.7       -2.8
   Romania           -1.3     -1.7       -2.8      -1.0      Romania            32.8          34.9         40.4        37.4          Romania           -3.0     -4.6        -6.1       -3.7
 Croatia              4.8      6.9       -1.0      5.6      Croatia             82.7          75.7         90.5        84.2        Croatia              0.2     -0.3        -6.1       -1.9
 Russia               5.4      4.3        2.1      1.0      Russia              28.1          27.7         30.5        27.7        Russia               2.6      1.8        -2.3       -1.1
 Serbia               2.5      0.9       -0.9      0.0      Serbia              62.6          60.2         66.5        61.6        Serbia               0.6     -0.2       -8.0        -2.0
 Turkey              -1.5      1.9        0.2      0.7      Turkey              56.4          58.0         65.0        57.3        Turkey              -3.5     -5.4        -7.7       -5.6

 Gov’t debt                                                 Policy rate
 (% GDP)             2018     2019   2020F      2021F       (%)                2018          2019        2020F        2021F        FX vs. EU          2018     2019      2020F      2021F
 CEE-EU              46.6     44.8       54.2     50.9      CEE-EU                                                                 CEE-EU
   Bulgaria          21.8     19.9       26.7     27.8       Bulgaria                -              -           -           -        Bulgaria         1.96      1.96       1.96        1.96
   Czechia           32.6     30.7       38.8     39.1       Czechia            1.75          2.00         0.25        0.50          Czechia          25.7      25.4       26.2        25.3
   Hungary           68.5     64.7       73.4     65.7       Hungary            0.90          0.90         0.90        0.90          Hungary           322      331         340        345
   Poland            48.5     45.6       55.2     50.7       Poland             1.50          1.50         0.05        0.75          Poland           4.30      4.26       4.40        4.35
   Romania           34.7     36.9       44.5     43.1       Romania            2.50          2.50         2.00        2.00          Romania          4.66      4.78       4.85        4.95
 Croatia             74.7     73.2       87.5     82.6      Croatia                  -              -           -           -      Croatia            7.42      7.44       7.50        7.50
 Russia              12.1     12.5       14.7     15.1      Russia              7.75          6.25         5.50        5.50        Russia             79.5      69.3       80.9        82.6
 Serbia              54.4     52.9       64.0     58.0      Serbia              3.00          2.25         1.00        1.00        Serbia            118.2    117.6       118.2      118.7
 Turkey              30.4     33.1       38.9     37.5      Turkey             24.00        12.00          9.00        9.00        Turkey               6.1      6.7        7.4         8.1

                                                                                                          Source: National statistical agencies, central banks, UniCredit Research

UniCredit Research                                                                       page 15                                                              See last pages for disclaimer.
April 2020                                                                April 2020                                             CEE Macro & Strategy Research
                                                                                                                                                          CEE Quarterly

                                        CEE Strategy:
                                        More weakness before risk appetite returns
Elia Lattuga,                           ■   The large losses recorded in 1Q20 have been a rough awakening after the stellar returns
Co-Head of Strategy Research,
Cross Asset Strategist                      achieved in 2019 for EM assets. Credit spreads widened to their highest levels since the
(UniCredit Bank, London)                    2008-09 financial crisis, and we expect this economic recession to be deeper.
+44 207 826-1642
elia.lattuga@unicredit.eu               ■   Unprecedented support from monetary and fiscal authorities will cushion losses in financial
                                            markets and will fuel a sharp rebound in risky assets in 2H, in our view. However, markets
                                            remain exposed to more downside over next few months and we suggest keeping a
                                            cautious approach.
Risks are to the downside               Risk aversion has dominated the market over the past two months. The adjustment in the
before a sharp rebound in 2H
                                        level of risky assets in February and March was extremely deep and fast. The S&P 500
                                        drawdown of nearly 30% ranks among the top ten bearish moves since the 1950s, and even
                                        within such a sample, the recent sell-off was particularly rapid. Hence, It is not surprising that
                                        it caused large spillovers across several segments of the market. Credit premiums on most
                                        ratings widened sharply, while funding markets shut down. Even USTs and gold were
                                        disposed of in the hunt for USD liquidity, although the pressure was short lived. The spread of
                                        COVID-19 and its economic fallout raised concerns over energy demand. The drop in oil
                                        prices itself fueled another leg of sell-off across energy names on credit markets. At the end
                                        of 1Q20, based on data from the United Nations Office for the Coordination of Humanitarian
                                        Affairs (OCHA), countries comprising nearly 50% of global GDP had announced total or
                                        partial lockdown measures. Hence, a significant drag on global growth is in the cards for
                                        1H20. We believe that the ongoing slowdown will come with a fall in output more than twice
                                        as deep as that witnessed in 2008-09, but the recovery is expected to be swifter. Such a
                                        V-shaped path is still very uncertain, and we believe that risky assets might come under
                                        pressure again before sentiment improves by the end of 2Q. Our view for 2H is more positive.
                                        We forecast a sharp rebound in risky assets in 2H on the back of improving economic
                                        conditions, and fueled by the bold measures taken by monetary and fiscal authorities.

Unprecedented support by                Central banks have announced a wide range of easing measures in recent weeks. Actions
central banks
                                        range from rate cuts to liquidity provision across several segments of the market, including FX
                                        swap lines and asset purchases, and have been fine-tuned and/or stepped-up in response to
                                        market conditions. Among other measures, the ECB has committed itself to purchasing over
                                        EUR 1tn of public and private assets by the end of the year, while the Fed has announced
                                        unlimited quantitative easing (QE). Other major central banks have followed suit.

CHART 1: EM BOND PERFORMANCE                                                           CHART 2: CENTRAL-BANK LIQUIDITY ON THE RISE

                     1Q2020   2019   2018   2017     2016
 40%                                                                                                     Fed, ECB, SNB, BoJ & World FX reserves (stock)            12M Change (rs)
                                                                                            25                                                                                       4.0

                                                                                            20                                                                                       3.0

                                                                                            15                                                                                       2.0
                                                                                       USD tn


-20%                                                                                        10                                                                                       1.0

-40%                                                                                            5                                                                                    0.0
       LatAm Asia EMEALatAm Asia EMEA   A   Baa     Ba      B   Caa   1-3 7-10
                                                                      Year Year
              LC          HC-USD                  HC-USD               HC-USD                   0                                                                                  -1.0
                                                                                                Jun 04    Jun 06   Jun 08   Jun 10   Jun 12   Jun 14      Jun 16     Jun 18   Jun 20

                                                                                                                              Source: Bloomberg, Haver, UniCredit Research

UniCredit Research                                                           page 16                                                                   See last pages for disclaimer.
April 2020                                                                       April 2020                                             CEE Macro & Strategy Research
                                                                                                                                                                CEE Quarterly

                                               Chart 2 shows the total amount of liquidity provided by selected central banks (along with
                                               global FX reserves), which has been rising sharply recently. This trend will continue over the
                                               coming months as the announced asset purchases are implemented. The total amount of
                                               liquidity supplied to the market will easily break above previous record highs. Monetary policy
                                               is being counted on to provide a wide range of backstop measures to contain financial
                                               tightening and cushion the impact of the COVID-19 pandemic on economic activity. These
                                               measures have already helped equity markets recover some of their earlier losses and have
                                               contributed to stabilizing bond and funding markets, where sellers predominated in the first
                                               half of March. Pockets of stress remain and whether such liquidity will flow in sufficient
                                               quantity to emerging markets also depends on developments in risk appetite.

Developments in risk appetite                  Risk aversion has risen sharply on the back 1Q losses. We track the level of risk aversion with
                                               a series of indicators including both market and survey-based risk measures, which are part
                                               of our risk dashboard 6. Chart 3 shows one of the indicators we track, our risk appetite index
                                               (RAI), along with 3M returns for EM currencies (using MSCI weights). The RAI is built on the
                                               Spearman’s rank correlation of returns and risks for a portfolio including a large number of
                                               instruments across asset classes and aims to measure investors’ sensitivity towards risk
                                               rather than the level of risk in the system. This makes it especially suitable for historical
                                               comparison. The RAI ranges from -1 to +1, and has recently crossed below -0.6, marking its
                                               fifth weakest point since 2000, at levels comparable with the 2008-09 financial crisis period.
                                               The RAI, as well as alternative risk aversion measures, suggests caution when interpreting
                                               the recent rebound in risky asset prices. Uncertainty as to the extent of the economic loss is
                                               still significant and large bearish turns on global markets often come with wider implications
                                               because of position shedding, margin calls and impaired access to funding, all of which might
                                               continue to expose the underlying fundamental weaknesses markets have long been ignoring.

CHART 3: WEAK APPETITE FOR RISK                                                                 CHART 4: EM HARD CURRENCY INDEX PERFORMANCE

                          RAI        EM FX (MSCI weights) 3M return
                                                                                                                                    previous 12M     Last 3M
     0.80                                                                        25                     2000

                                                                                 20                     1800
                                                                                 15                     1600
                                                                                 10                     1400
     0.20                                                                                               1200
                                                                                                spread bp

     0.00                                                                        0                      1000

                                                                                 -5                         800
                                                                                 -10                        600
                                                                                 -15                        400
    -0.60                                                                                                   200

    -0.80                                                                        -25                         0
        Jan 00   Sep 02   Jun 05   Mar 08   Dec 10   Sep 13    Jun 16   Mar 19                                    -80   -60   -40         -20           0        20         40          60
                                                                                                                                         Total return (ann.)

                                                                                                                                             Source: Bloomberg, UniCredit Research

                                               Analyzing the performance of hard-currency (USD) bonds over the past three months and the
                                               previous twelve shows that during the sell-off higher yielding bonds have generally
                                               underperformed. Carry could do little to offset the large adjustment in the level of credit
                                               spreads. Moreover, the dispersion in performance was larger among higher yielding bonds,
                                               with a fat left tail in the total return distribution. Note also that over the chosen period, the
                                               performance of UST was positive – USTs were among the few assets that managed to
                                               remain in demand in (or for most of) 1Q. Repatriation probably supported this trend.

    The UniCredit Risk Dashboard: Our framework for tracking developments in risk appetite, Global Themes Series No. 41, July 2018, UniCredit Research.

UniCredit Research                                                                    page 17                                                                  See last pages for disclaimer.
April 2020                                                                April 2020                                   CEE Macro & Strategy Research
                                                                                                                                           CEE Quarterly

Outflows have prevailed                     In fact, the weak EM bond performance shown above was also associated with large outflows
                                            from EM portfolios. IIF data shows that over the month of March, more than USD 80bn of
                                            outflows hit EM equity and bond portfolios, an amount comparable (but higher) than during
                                            the 2008-09 financial crisis . Outflows across equity markets have been larger than in 2008-09 and
                                            flows might quickly come back given the reactivity of global central banks, assuming that risk
                                            appetite returns to the market, something we expect to happen towards end of 2Q.
Funding risks and deteriorating             As portfolio flows dried up and with primary markets being shut down for most issuers,
credit profiles
                                            refinancing risks started to become material for a larger part of the market. According to the
                                            IIF, USD 30bn of redemptions fall due from EM sovereigns in 2020 (their coverage includes
                                            30 emerging countries) and nearly USD 600bn when all sectors (sovereign, non-financial and
                                            financial corporates) are accounted for. This includes redemptions relative to bonds in all
                                            currencies (USD equivalent). Issuance from EM sovereigns has slowed down since mid-
                                            February, after a good start to the year. In absolute terms, the amount coming to the market in
                                            1Q20 was nearly 20% short of that seen in 2018 and 2019. Usually 1Q accounts for 35-45%
                                            of the supply for the year as issuers tend to front-load primary market activity. In 2020, larger
                                            budget deficits speak for higher funding needs compared to 2019. Hence, probably less than
                                            25% of this year’s supply was completed in 1Q20. Considering the higher spread levels and
                                            the support from central bank liquidity, issuance could accelerate quickly and the funding gap
                                            bridged if market tensions ease. We are already seeing a significant improvement in
                                            European and US IG markets, which could extend to lower-rated, riskier issuers. However,
                                            the extent of investor demand across the various risk profiles and how quickly it will adjust
                                            towards pre-crisis standards remains very uncertain. Moreover, a huge amount of unexpected
                                            supply is coming to the market as a result of the fiscal actions to fight the economic
                                            implications of the COVID-19 crisis. Central banks will help to absorb this increase in
                                            sovereign issuance, likely adapting the size (e.g. unlimited QE) or the composition of their
                                            asset purchases (e.g. ECB). However, especially for lower-rated issuers, funding costs might
                                            remain elevated and above the level of maturing bonds which, along with rising debt levels
                                            across regions (currency depreciation included), would add to debt-sustainability risks over
                                            the medium term. In this environment, rating actions are a material threat as shown by
                                            downgrades of several LatAm and African sovereign announced since mid-March, and might
                                            contribute to keep market sentiment shaky.

MONTHLY PORTFOLIO FLOWS INTO EM                                                          SOVEREIGN ISSUANCE (USD BN EQUIVALENT)

                                    Debt   Equity                                                                 CEEMEA   ASIA   Latam
    80                                                                                    200
    20                                                                                    120

     0                                                                                    100
   -60                                                                                     20

   -80                                                                                      0
                                                                                                1 2 3 4 5 6 7 9 10 11 12   1 2 3 4 5 6 7 9 10 11 12          1 2 3
  -100                                                                                                     2018                       2019                    2020
     Jan 05    Jan 07   Jan 09   Jan 11    Jan 13   Jan 15   Jan 17   Jan 19

                                                                                                                       Source: IIF, Bondradar, UniCredit Research

UniCredit Research                                                             page 18                                                    See last pages for disclaimer.
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