Pricing power: the real secret to success in post-COVID time

Over the past three years, the global economy went through a roller-coaster. A global pandemic unexpectedly hit us. Several lockdowns were introduced to avoid mass deaths. But it severely disrupted the functioning of the economy. Governments and central banks all over the world injected an unprecedented amount of liquidity to prevent a global economic disaster and to preserve the population’s purchasing power.

The global pandemic Quantitative Easing (which only refers to central bank injections) reached $12tr. This, along with global trade and global demand disruptions and the Ukraine war, caused a period of ‘permanent’ inflation.

In the CEE region, inflation is running at double digits. It has reached a peak in some countries (Czech Republic, for instance) but not in others (Poland, for instance). We are now using the old playbook to fight inflation: increase the cost of capital via higher interest rates and reduce liquidity in the economy. Since October 2022, one third of the global pandemic Quantitative Easing has been withdrawn. But reducing inflation is not that easy. At the same time, Japan and China have jointly injected a surprise $1tr liquidity hit. On the bright side, this helped keep markets afloat. It also partially explains higher risk appetite on the FX market since the end of 2022 until very recently. On the downside, financial conditions are probably not tight enough to really push inflation significantly lower. Going forward, the economic environment will remain challenging. A few months ago, economists called for a recession to lower demand and, thus, inflation. The Czech Republic and Hungary have entered a technical recession defined as two quarters of consecutive GDP contraction. Unfortunately, there is no sign that it is of much help against the inflation headache.

„We believe that inflation is partially structural – which explains why core inflation remains elevated in most countries. We won’t get back to the central bank’s inflation target of around 2% or slightly above depending on the country anytime soon. We need to learn how to live in a world of ‘permanent’ high inflation – meaning that the long-term average Consumer Price Index will likely hover around 3-4 % annually in the eurozone and probably one or two points higher in most CEE countries. Add on top of that geopolitical risk in the region with Russia looking to destabilize several countries (Moldavia is one of them) and you have a perfect storm”, said Johan Gabriels, iBanFirst Regional Director.

There is never a good time

We are used to living in a low inflation environment, but the 2% inflation target is not an historical norm. High inflation is the norm. However, this does not mean doing business is impossible. You have probably never heard about William E. Simon. He was a conservative U.S. Treasury secretary in the 1970s – another period of very high inflation. It won’t be an offense to say he has not achieved much in these two years and half tenure. He is, however, famous in the business industry because he is one of the pioneers of leveraged buyouts (LBO) in the 1980s. This is a sophisticated financial technique to acquire a company using a significant amount of borrowed money (bonds or loans). Simon founded one of the first LBO companies, Wesray, in 1981. At that time, the U.S. economy went through a double-dip recession engineered by the U.S. Federal Reserve to end a long period of double-digit inflation. Interest rates were extremely high, with no comparison with today’s standards. Bank failures were starting in the United States. Business and consumer confidence were at their worst. The geopolitical situation was tense. The threat of a nuclear war was still present. The USSR had just invaded Afghanistan and a Communist revolution was happening in Grenada – just 4000 kilometers from the United States. Does it sound familiar? Yet, Simon made a fortune in one of the worst modern economic periods. In its most celebrated transaction, Simon paid $80.5 million to purchase Gibson Greetings Inc. – the United States’ third largest greeting card manufacturer in January 1982. When he took Gibson public at a valuation of $290 million in May 1983, he earned about $70 million. What is the lesson of the story? No matter the circumstances, there are always opportunities of success for brave and smart souls.

The pricing power is back

Before the pandemic, the global economy was flirting with the risk of deflation. During that period which started in the aftermath of the Global Financial Crisis of 2007-08, the pricing power – the cushion companies rely on – had basically disappeared, with a few exceptions (luxury and high-tech companies, for instance). With the pandemic, the Ukraine war, and their consequences, we have entered a new economic paradigm. The pricing power is back, not only for a few but for the majority. In several sectors, price hikes have exceeded cost rises. This is very noticeable in the CEE region. The latest Eurostat data from the third quarter 2022 (the last available data) shows gross operating surplus in the corporate sector – a measure of post-wages profit – rising by an annual 34% in Hungary, 22% in Poland and 16% in the Czech Republic. That is far above the growth rates of 10% the European Union as a whole and just 8% for the euro zone. This will likely continue, at least in the short term.

In the February PMI surveys covering the European Union, a record number of business owners expected to hike prices in the service sector in the coming months. This is unique. As the European Central Bank and the National Bank of Hungary have recently highlighted, we are now facing a price-profit loop. Businesses of all sizes are now able to increase prices. This is good for corporate margins. Of course, pricing power is bigger for large companies. The more we go down in size, the more the pricing power will depend on how specialized and internationalized the company is.

How do we explain that? Competition has significantly decreased over the past three years. This is a real game-changer for most companies. This also explains why the expected wave of business bankruptcies has not happened yet. Contrary to what many believe, European companies are well-positioned to overcome the current economic environment. This is not a recessionary environment (at least at the continental level). Instead, it’s a period of quickly oscillating expansions/contractions, growth fluctuating at low levels and unemployment rising but still low because companies are not ready to give up the employees whom they had so much difficulty hiring (which raises the risk of job zombification). This is quite new, we agree. It is probably harder to initially address than the standard recession playbooks. Leaders need to think differently, out-of-the box and companies need to show flexibility, particularly in the work organization and supply chains, exactly what has been done during the Covid time. The worst is never certain. Look at the past few years to be convinced of this.

Euro adoption

For CEE-based companies, there is another piece of good news. Romania is expecting to adopt the euro in 2026 and Bulgaria in 2025. In the short-term, the euro adoption will generate one-off costs for entrepreneurs (adjustment of information systems, currency exchange, conversion of prices, dual pricing, personnel training etc.). Based on prior euro adoption, the cost could range initially from 0.3 to 0.8 % of GDP. But this can be lowered. A short dual circulation period should minimize costs for retailers, for instance.

In the long run, the euro adoption is beneficial. It will facilitate the inflow of foreign investment into the two countries. Entry to the euro area will significantly increase their stability as perceived by foreign investors. Investors will also save on transaction costs. We expect that foreign direct investments will be one of the driving forces for increasing foreign trade. According to our rough calculations, the growth of foreign trade by 1 % in Romania and in Bulgaria could increase the GDP by one third of a percentage point. In the long run, this could mean that the total increase of GDP will be by 7 to 20 %. Of course, such growth will take place gradually and it will depend on the overall macroeconomic situation. But this will ultimately be positive. There is, however, no plans for Hungary, Poland, and the Czech Republic. In the case of Hungary, the prevalent issue of the freezing of Hungarian EU funds and the delay in implementing the actions on the findings is increasing uncertainty for local companies (especially for the construction sector which has been a major driver of growth in the past years).

But this does not seem to negatively impact foreign investors’ perception of the country as proved by the resilience of the HUF in a risk-adverse environment. Despite the mounting risks (especially regarding the banking stress), CEE companies are well-positioned to navigate uncertainty in 2023.

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