2015 to be positive year again for Central and Eastern Europe

UniCredit Economics & FI/FX Research:

2015 to be positive year again for Central and Eastern Europe

• Stronger economic growth in the eurozone, "quantitative easing" by the ECB and lower oil price create favourable general conditions
• Pressure for further fiscal consolidation in young EU Member States eases

Economic growth in the eurozone, which has recently picked up and should firm to 1.4 percent in 2015 and further to 1.8 percent in 2016, ought to ensure another good year for Central and Eastern Europe in 2015. This is one of the key messages of the latest "CEE Quarterly", which is published every quarter by UniCredit Economics & FI/FX Research and is devoted to economic activity in the region. Exports from the region stand to benefit in particular from the economic recovery in the eurozone, while the ECB's "quantitative easing" should stimulate capital flows and keep financing costs low at the same time. Excess supply and sluggish demand are likely to keep oil price depressed for a while, which should provide a boost to disposable incomes and consumption.

Reforms and fundamentals vital for faster growth

The favourable external environment also offers local central banks the opportunity to keep interest rates at record lows for an extended period of time, prolonging the accommodative monetary stances in place. Low financing costs could provide some scope for fiscal support, especially in countries where government deficits and debt are at moderate levels. "But not all countries in Central and Eastern Europe will be able to benefit to the same extent from the favourable conditions", outlined Lubomir Mitov, CEE chief economist at UniCredit. "Countries with solid fundamentals and advanced reforms will draw the lion's share of the benefits from the current situation." These countries (EU-CEE) include the Baltic states, Poland, Slovakia, Slovenia, the Czech Republic and Hungary, which joined the European Union in 2004, as well as Bulgaria and Romania, which became EU members in 2007.

These export-focused EU-CEE countries should be able to utilise their competitive advantages and close economic ties with Germany to the fullest extent. Real GDP growth should accelerate to 2-3 percent this year as a result, except for Poland, where growth will exceed 3 percent. However, it seems unrealistic at present to expect higher growth rates of growth without a stronger recovery in the eurozone. Although many EU-CEE economies now have negative inflation rates we are not likely to see any sustained deflationary scenario. This is because the declines in inflation are largely caused by cheap crude oil and the cuts in regulated prices, whose effects are largely exhausted. Consumer prices appear to have b bottomed out already, but even so, inflation will remain subdued well into next year.

With public deficits and debt at moderate levels and economic growth picking up, stronger fiscal consolidation does not seem necessary this year. The only exceptions among EU-CEE countries are Hungary, which is still heavily dependent on foreign investors and exhibits a high public debt level, and Bulgaria, whose deficit rose sharply last year following the rescue of a large private bank.

Although the growth outlook is firming up and the resilience to external shocks is rising, the equilibrium achieved is not likely to be sustainable in the medium term, neither politically nor socially. This is because annual growth of 2 to 3 percent, in combination with expected low inflation, would significantly slow the economic convergence of the region to the "old" EU Member States. Slower convergence in turn would lead to more emigration towards the older EU countries at the cost of potential growth for the EU-CEE states. As consequence, low growth and adverse demographics would boost ageing costs to unsustainable levels, and pressure EU-CEE countries to take politically difficult decisions with regards to their pension and healthcare systems. However, hardly any country will tackle these issues as long as its near-term financing seems secure.

Ukraine and Russia with weakest performance in the region

For the region´s two leading commodity exporters external circumstances have deteriorated sharply. Ukraine and Russia do not just suffer from a sharp drop in commodity prices, but also - albeit for different reasons - from the loss of access to foreign markets. "The weaknesses of both countries have been obvious already before the conflict in Eastern Ukraine started and they are rooted in structural rigidities and an incomplete reform agenda", stated Lubomir Mitov.

Ukraine has lost nearly one tenth of its economic potential due to war-related damages. Although the new IMF program may prevent a meltdown for now, it is not sufficient to put the economy on a sustained growth path until peace is achieved. Russia is facing different but not much easier challenges: The drop in oil prices and the loss of access to foreign markets due to the sanctions have exposed the country´s dependency on oil and gas and on capital inflows. The evolved financing gap has forced the authorities to let the ruble depreciate sharply despite losing a quarter of FX reserves. Both countries will face recession this year, with the Ukrainian economy improving only slightly in 2016.

Risks: interest hikes by the Fed and intensified fighting in Ukraine

Despite the generally positive climate, significant risks remain: For example, the interest rate hikes expected later this year from the US Federal Reserve could exert an adverse impact on global risk appetite and result in stagnation or a reversal in capital flows to Central and Eastern Europe. This would have a negative effect particularly on countries such as Turkey, Croatia and Serbia, all of which have significant economic imbalances and depend heavily on foreign capital. The recent intensification of fighting in eastern Ukraine constitutes another risk. This could exert an even greater influence on the region than before, particularly due to interruptions in the supply of energy and a further tightening of international sanctions.

Vienna, 29 April 2015