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