Published: October 10, 2014
Following a strong start to 2014, challenges to growth are rising in Central and Eastern Europe but differentiation is of increasing importance. Central Europe has achieved an impressive amount of consolidation over recent years, putting economies in a much better position to take advantage of global recovery in activity. Countries in South East Europe have lagged on reform and growth is set to remain more muted. Turkey remains amongst the growth leaders in the region, supported by a strong public sector and banking sector balance sheet but is vulnerable to external shocks. In Russia, our concerns surrounding the medium- to long-term growth outlook have increased significantly as geopolitical tensions undo a multi-year period of progress on trade and financial liberalisation.
Central Europe benefits from a number of advantages, including flexible and competitive labour markets, a role as a key part of EMU’s (European Monetary Union) and in particular Germany’s industrial production engine and access to another round of EU funds aimed at agriculture, infrastructure and human capital. In contrast with other emerging market regions globally, many of the newer EU states have done a considerable amount of work to improve competitiveness, budget and current account balances over recent years. And as the EMU banking system recovers, the newer EU states stand to benefit both directly and indirectly given that foreign owners remain dominant.
All of the above means that the recovery in activity that has been under way since mid-2013 should continue. Investment recovered in many Central European economies even before the start of the 2014-2020 EU fund programming period. Hungary and the Czech Republic are two examples of countries that continue to benefit from foreign direct investment to their tradables sector, supporting strong growth in industrial production and exports. The combination of narrower budget deficits and improving government revenues also means that fiscal policy is no longer acting as a significant drag on growth – as has been the case in the past – while interest rates are at record lows and set to adjust upwards only gradually. Data over the course of 2Q14 acts as an important reminder of the fact that the speed of recovery will at times slow, with events in Ukraine posing a significant risk to the outlook. Nonetheless we expect the recovery to continue over the coming quarters. A temporary weakening of demand from the Eurozone could be offset by stronger domestic demand in 2H14.[[[PAGE]]]
Reform efforts in the Balkans have lagged Central Europe, dragging on growth, though there are signs of improvement. While Bulgaria runs a strong fiscal position, recent banking sector woes amongst domestically-owned banks highlighted institutional shortfalls which the domestic authorities are now taking steps to address. Potential growth in Croatia, Serbia and Slovenia is dented by inflated public sectors which often crowd out the private sector. Fiscal consolidation efforts are underway in all three countries, Croatia and Slovenia under the supervision of the European Commission while Serbia is edging towards an IMF programme. If sufficient in size, efforts should stabilise public debt to GDP ratios while improving macro-stability but over the coming quarters growth performance across these economies is set to continue to underperform Central Europe.
Growth in Turkey has been more impressive, averaging almost 5% per annum over the past decade, supported by large improvements in the sovereign’s balance sheet and a well-capitalised banking system. Looking ahead the domestic authorities remain upbeat. But as is the case in other emerging markets globally, Turkey has exhausted many of its easy sources of growth in recent years. Interest rate convergence, by and large, is now done while there are increasing structural constraints on credit growth. A low level of foreign reserves leaves the economy vulnerable to external shocks while a low savings ratio constrains potential growth.
Under our baseline scenario Turkey continues to post growth of between 2-3% year-on-year over the coming quarters, supported in part by export growth, but official targets of 4-5% yoy real GDP growth are likely to prove out of reach in the absence of further structural reforms. Fiscal measures to boost the domestic savings ratio and protect the economy against an external shock may entail some short-term pain but will be beneficial in the long term. Maximisation of Turkey’s competitive advantage in the form of population growth via an increase in labour force participation would also serve to boost potential growth.
Looking ahead to the coming 12 months, Russia generates most uncertainty within CEE, both for Russia itself and the region more broadly. Events have escalated rapidly since February, re-inforced by the tragic events surrounding the MH17 flight and renewed fighting in South-Eastern Ukraine, but even prior to Crimea, the Russian economy was undergoing a structured slowdown in growth. The economy was being forced to adjust away from an environment of ever-increasing oil prices towards one of stable oil prices at a time when a weak business environment meant that the domestic capital outflows extended well beyond a natural recycling of oil revenue and were weighing on potential growth. Events in Ukraine have forced further structural change upon Russia via a number of channels. Financial sanctions in theory limit access to foreign financing at a time when Russia’s dependence on foreign capital had increased significantly while sanctions on various imports limit Russia’s ability to expand energy production capabilities over a longer term horizon.[[[PAGE]]]
In the next one or two quarters, a combination of factors should translate into a modest contraction in economic activity in Russia but our concerns centre on the outlook over a longer horizon. A halt to domestic capital outflows, fiscal efforts to support activity, a forced shift from imported to domestically-produced goods and efforts by domestic corporates to accumulate USD all help smooth the downturn for now. But should sanctions prove lasting, or even escalate further, Russia will be at risk of a persistent and accelerating recession. A visible de-escalation of geopolitical tensions combined with the implementation of a comprehensive structural reform programme aimed at diversifying production away from energy and improving the business environment would prompt us towards a much more positive outlook.
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