Economic Snapshot for Central & Eastern Europe

August 1, 2018

Second-quarter growth seen moderating despite resilient domestic demand

Available data suggests that the Central and Eastern European (CEE) economy lost steam through the first half of the year, slowing somewhat from last year’s breakneck growth spurt. Ahead of preliminary estimates for the second quarter, leading data hints that regional growth moderated through June on weaker external demand stemming from this year’s slowdown in the Eurozone. That said, the piping-hot domestic economy that propelled the region’s 4.4% annual expansion in the first quarter appears to have kept pace in recent months despite, in some cases, running up against labor shortages. Moreover, an investment boom has been underway across much of the region, supported by cheap financing and greater absorption of EU structural funds. As it stands, FocusEconomics peg second-quarter growth of the CEE economy at 4.1% year-on-year.

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Most of the region’s major economies, including the Czech Republic, Hungary and Poland, are expected to have notched slower growth in the second quarter despite rising employment and rapid wage growth. As was the case across much of the region, in Poland, headline growth appears to have been constrained by sharply lower demand from key European trading partners. Meanwhile, in line with ebbing external demand, industrial metrics across the region have been tapering, from the Baltic economies to Slovakia and Slovenia. Romania, on the other hand, continued dealing with an overheating economy but is still likely to have seen growth pick up moderately from the first quarter; it appears that soaring inflation and higher borrowing costs were insufficient in taming household spending in the quarter.

On the political front, the Czech Republic ended months of political impasse on 12 July when Prime Minister Andrej Babis and his proposed ANO-CSSD coalition survived a confidence vote in parliament thanks to support from the Communist party. In striking a deal with the fringe group, Babis installed his two-party minority government into power and ended more than eight months in the role of government caretaker. Although it remains to be seen what, exactly, the communists will get from the deal, neither fiscal nor foreign policy are expected to be upended by the incoming government.

Meanwhile, in Poland and Hungary, relations with the European Union (EU) worsened in recent weeks as the European Commission (EC) proceeded with inquiries into laws recently passed by both country’s governments. In Poland, the EC began investigating whether the EU’s fundamental values had been infringed upon amid the ruling Law and Justice (PiS) party’s recent purge of the Supreme Court. In Hungary, recent laws criminalizing the support of undocumented migrants were referred by the EC to the European Court of Justice (ECJ). Tensions with Brussels are running high across the CEE economy—Romania also continued butting heads with the bloc’s institutions in recent weeks—as lawmakers gear up for talks on the 2021–2027 EU budget, which is expected to divert a substantial portion of the CEE region’s structural funding southward to economies like Greece and Italy.

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Domestic demand to drive solid outturn this year

Low unemployment, strong wage growth and the ongoing investment boom, which is being aided by still-low interest rates and high absorption of EU structural funds, are seen driving another strong outturn for the CEE economy this year. Regional growth, however, is seen ticking down from last year’s decade high as demand within the Eurozone, the region’s largest trading partner, takes a breather. Moreover, rising inflation—and, in particular, the recent jump in fuel costs—could bruise spending. Impacts from earlier fiscal stimulus, meanwhile, are expected to all but fade out. All told, regional growth is seen clocking in at 4.0% this year, unchanged from last month’s forecast, and easing to 3.3% next year.

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Downside risks to the CEE economy have intensified amid the deterioration of global trade relations, threatening the region’s short-term growth trajectory. Threats by U.S. President Donald Trump to escalate the trade war with the EU by slapping tariffs on the bloc’s automotive sector, if implemented, could stifle one of the region’s most important industries and would hit economic activity especially hard in Slovakia and the Czech Republic.

Poland and Hungary, two of the region’s major players, along with Estonia, saw their 2018 growth forecasts revised upward this month on the heels of solid first-quarter outturns. On the other hand, the Czech Republic and Romania saw their full-year prospects downgraded following rocky starts to the year. Meanwhile, 6 of the region’s 11 economies saw no changes to their forecasts.

Slovenia, Poland and Romania are expected to be the fastest-growing economies in the region, each expanding over 4.0% this year. On the flipside, only Croatia—the region’s worst performer this year—is expected to grow at below 3.0%.

POLAND | Domestic demand stays firm in Q2 amid Warsaw’s standoff with Brussels

Second-quarter growth appears to have moderated somewhat from the exceptional outturn at the beginning of the year. One the one hand, buoyant retail sales and the further tightening of the labor market through June suggest another quarter of strong household spending. Moreover, fixed investment looks to have continued riding this year’s wave of EU structural funding and is poised to keep benefitting from still-low borrowing costs. On the other hand, industrial gains have begun tapering off and higher input costs—thanks to the weak zloty—have been weighing on manufacturers’ sentiment. Meanwhile, exports were sluggish into May as the EU-wide slowdown hit external demand. In the ongoing standoff between Warsaw and Brussels, in July, the government’s controversial judicial reforms became the target of a European Commission-led inquiry. Although investment has thus far gone unscathed, political uncertainty has been casting an increasingly long shadow on the resilient economy.

Domestic demand will remain in the driver’s seat this year. Although consumer spending will be upbeat, employment gains could begin easing as slack fades from the labor market. Moreover, fixed investment will benefit from improved absorption of EU structural funds. Export growth, meanwhile, is set to moderate somewhat as demand cools across Europe. Fiscal slippage ahead of next year’s elections may widen the deficit, while growing uncertainty over the 2021–2027 EU budget is hanging over the long-term outlook. FocusEconomics analysts expect growth of 4.4% in 2018, up 0.1 percentage points from last month’s forecast, and 3.5% in 2019.

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CZECH REPUBLIC | Deal with communists installs Babis’ two-party coalition into power

Monthly data shows the economy continued to lose some traction in Q2, following two straight quarters of cooling growth through Q1. After rebounding strongly in April, industrial production growth decelerated markedly in May on the heels of lower output of vehicles and pharmaceutical products. Furthermore, retail sales growth more than halved in the same month despite an exceedingly tight job market and recent wage hikes. Although the unemployment rate dropped to a new all-time low in June, consumer confidence also fell, which may imply another soft month for retail sales. In the political arena, Prime Minister Andrej Babis survived a parliamentary confidence vote on 12 July, thanks to the support from the Communist Party, that enabled his two-party minority government to finally take office—putting an end to more than eight months of political stalemate. It is expected that the new government will not change the direction of economic policy.

The economy is expected to lose steam this year, but growth should remain robust overall. Healthy consumer spending, supported by high wage growth, rising employment and low interest rates, and government plans to increase spending, facilitated by the fiscal surplus on hand, should underpin economic activity going forward. Given the highly export-dependent nature of the country’s industrial base, the main downside risk to the outlook stems from a slowdown of external demand, particularly from the EU. FocusEconomics Consensus Forecast panelists see GDP growing 3.4% in 2018, which is down 0.1 percentage points from last month’s projection, and 3.0% in 2019.

ROMANIA | Economy shows further signs of overheating in Q2

Growth likely strengthened in Q2, following a sharp deceleration in Q1. Consumer spending appears to have regained some steam, benefiting from tight labor market conditions and wage gains, as retail sales were solid in April and May. Moreover, exports expanded at a solid pace in the same two months. However, data for the first five months of the year shows that the current account deficit widened significantly in annual terms. In addition, fiscal data for January-June continued to show a deterioration in the budget deficit, which does not bode well for the rebalancing of the economy. In early July, President Klaus Iohannis sacked the chief anti-corruption prosecutor following a constitutional court ruling saying he could not oppose a dismissal request by the justice minister. This is set to exacerbate the debate on the independence of the country’s judiciary between the government and EU institutions.

Higher inflation and a loss in consumer confidence should lead to a marked slowdown in consumer spending this year, denting GDP growth. Although the expansion in fixed investment should gain some strength, low EU funds absorption will limit the extent of the acceleration. Downside risks stem from widening fiscal and current account deficits. FocusEconomics panelists expect growth of 4.1% for 2018, down 0.1 percentage points from last month’s forecast, and 3.6% in 2019.

HUNGARY | Activity appears to strengthen in Q2 as relations with EU deteriorate

Available data for Q2 points to another quarter of strong growth. This follows a remarkable economic performance in the first quarter on the back of buoyant domestic demand. Extremely tight labor market conditions and improved consumer sentiment seem to have buttressed household spending, as shown by surging retail sales in the first two months of the quarter. Construction activity also continued to climb in both April and May, supported by the rise in real estate prices, while growth in industrial production regained some steam after decelerating throughout Q1. Moreover, upbeat business confidence throughout Q2 suggests fixed investment remained quite strong. In the political arena, however, relations between Hungary and EU institutions continue to sour. In mid-July the European Commission decided to refer the country to the European Court of Justice after the government passed a law that threatens to criminalize some forms of support to undocumented migrants.

Private consumption is set to remain buoyant this year, supported by robust wage hikes, a tight labor market and rising consumer confidence. Additionally, fixed investment should continue to soar, benefiting from strong inflows of EU funds, still-low interest rates and lower corporate taxes. On the other hand, weaker demand from the Eurozone will weigh on export growth; nevertheless, the current account will remain firmly in surplus. The main downside risks stem from potential capital outflows due to the Fed’s tightening cycle and the introduction of tariffs on car imports from the EU by the U.S. FocusEconomics panelists see the economy expanding 4.0% in 2018, up 0.1 percentage points from last month, and 3.1% in 2019.

MONETARY SECTOR | Higher fuel costs send inflation up in June

According to a preliminary estimate produced by FocusEconomics, inflation climbed for a fourth straight month in June to land at 2.9% (May: 2.6%). Higher prices were recorded in all but 1 of the region’s 11 economies, namely Lithuania. Across the region, inflationary pressures have been building in line with this year’s rapid rise in oil prices. Strong consumer-spending dynamics throughout the CEE economy have also lent upward support.

As it stands, still-low inflation has given the region’s policymakers room to keep their respective monetary policies accommodative this year and, by and large, the region’s central banks appear set to delay their tightening cycles until necessary in the interest of spurring the ongoing investment boom. In Poland and Hungary, inflation came within striking distance of each central bank’s midpoint target in June, giving officials space to leave rates unchanged at their July meetings. Meanwhile, in Romania, inflation continued its upward trajectory in June but a sharper-than-anticipated slowdown in the first quarter kept officials from hiking rates.

Amid rising fuel costs and robust consumer-spending gains, inflation across the CEE economy is seen averaging 2.6% this year, up a notch from last month’s forecast. Next year, inflation is seen roughly stable at 2.5%.

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Christopher Thomas

Economist