Economic Snapshot for Central & Eastern Europe

October 3, 2018

CEE economy notches solid Q2 outturn, but growth continues to taper

Complete data confirmed that internal demand was firmly in the driver’s seat of the Central and Eastern European (CEE) economy in the second quarter. According to a comprehensive estimate by FocusEconomics, regional growth came in at 4.2% year-on-year in the second quarter, matching the preliminary estimate although down a couple notches from the 4.4% outturn at the outset of the year. Low unemployment, cheap borrowing costs and strong absorption of EU structural funding have fueled robust demand at home. Nevertheless, growth has waned considerably since last year amid a slowdown in the Eurozone—the region’s major trading partner—and the broader pullback in global trade. Moreover, in line with this year’s cool-off, available third-quarter data suggests regional growth continued moderating into the second half of the year due to the further ebbing of European demand and the onset of Turkey’s economic crisis, both of which are likely to have bruised exports in the quarter.

A handful of countries constrained regional growth in the second quarter. In Bulgaria and Czech Republic, solid domestically-driven gains were offset by waning demand from key European trading partners. Growth in Poland, the region’s heavyweight, also moderated—albeit marginally—as fixed investment took a breather amid tax rewrites. Meanwhile, out of sync with its regional peers, weaker household-spending gains dented the Slovenian economy as inflation ate into consumers’ purchasing power.

More broadly throughout the region, however, the narrative was upbeat. Across the remaining seven economies, including the Baltic economies, Hungary and Romania, the blazing pace of homegrown demand translated into faster growth in the second quarter. That said, the latter two economies present a stark contrast; growth hit a four-year high in Hungary on robust household spending whereas, in Romania, similar gains have increasingly crowded out investment and caused the economy to overheat. Highlighting the benefits accrued to some of the region’s more open economies, Croatia and Slovakia also notched impressive gains in their respective external sectors.

On the political front, tensions with the European Union ratcheted up in recent weeks as lawmakers in Brussels adopted a more litigious stance against the alleged breaching of EU laws and values. With respect to Hungary, the European Parliament triggered Article 7 on 12 September over the Orban government’s perceived undermining of democracy and the rule of law. Meanwhile, in late September, EU lawmakers sued the Polish government over its recent judicial reforms, citing the erosion of the courts’ independence. Both cases are expected to be protracted affairs and most analysts see few immediate downside consequences for either economies. Taken together, however, they paint an alarming picture of the growing schism within the EU—an east-west divide drawn along Cold War-era lines. Although the region’s heavy-hitters have experienced stellar growth in recent years as EU-linked investment underpinned gains, the gush of structural funding could soon be reduced as the EU negotiates its upcoming 2021–2027 budget amid major differences of opinion on democracy, the rule of law and immigration. The expected results of October’s local elections in Poland, in which the ruling Law and Justice (PiS) is seen performing well, are only likely to exacerbate matters and further highlight the region’s continued support for right-wing populism.

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CEE economy to slow in 2019; downside risks persist

On the heels of a robust two-year growth spurt, the CEE economy is expected to slow next year as the region’s major players mature and approach the later stages of the business cycle. Low unemployment, higher wages, and still-accommodative monetary policy are seen cushioning internal metrics, although the outlook for external trade remains more uncertain. Moreover, greater downside risk for the region is materializing in the wake of this year’s slew of emerging-market (EM) crises. Although sturdy current-account balances are likely to shield most of the region’s currencies from a major selloff, spillover from Turkey’s economic meltdown could exacerbate capital flight in the short-term.

Regional growth is expected to clock in at an upbeat 4.0% this year before moderating to 3.4% next year, which is up 0.1 percentage points from last month’s forecast. Six of the region’s economies saw no changes to their 2019 growth forecasts this month, including heavy-hitter Czech Republic. Meanwhile, growth prospects were revised upwards for major-players Hungary and Poland, as well as for Estonia. On the other hand, overheating Romania, along with Latvia, had their growth projections downgraded this month.

Slovakia, Poland and Romania are expected to be the region’s top-performers next year, each expanding at or over 3.5%. On the flipside, only Croatia and Lithuania are expected to grow at below 3.0%.

POLAND | Q2 growth solid amid escalating EU standoff

Resilient domestic demand drove two of the strongest outturns of the past decade in the first half of the year, and available third-quarter metrics thus far suggest only some tapering of the growth spurt. Household spending has been firmly in the driver’s seat for some time, benefiting from a tight labor market and solid real wage gains. Fixed investment, on the other hand, paused its early-stage comeback in the second quarter despite upbeat structural funding as tax changes and new accounting rules took effect. Exports have been unexpectedly buoyant in recent months despite headwinds facing the external sector. On the political front, next year’s budget—which projects a fiscal deficit of 1.7% of GDP and lays out funding for the government’s new social initiatives, but could blemish the investment climate—now awaits parliamentary approval. Meanwhile, the European Union sued Poland in late September, citing the erosion of judicial independence in the country.

Economic growth is set to moderate next year in line with the maturing business cycle. Household spending should ease as labor-market tightness translates into slower employment gains, while fixed investment is expected to continue benefiting from cheap borrowing costs and the absorption of EU structural funds. Short-term downside risks include fiscal slippage ahead of next year’s elections, whereas uncertainty over the 2021–2027 EU budget hangs over the long-term outlook. FocusEconomics analysts expect growth of 4.6% in 2018 and 3.6% in 2019, up 0.1 percentage points from last month’s forecast.

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CZECH REPUBLIC | Minority government seeks communist support for 2019 budget

Although GDP growth cooled to a year-and-a-half low in Q2, available data points to upbeat economic activity in Q3. The unemployment rate remained steady in August after ticking up in July from an all-time low in June. This, coupled with nominal wage growth at its fastest in over a decade, have shored up household purchasing power, which likely contributed to the surge in retail sales in July. Similarly, on the supply side, industrial production expanded at the fastest annual clip so far this year in July, propelled by a jump in manufacturing output. That said, sound hard data has come at odds with leading indicators: Consumer confidence, business sentiment and the manufacturing PMI averaged lower in Q3 compared to Q2. Meanwhile, Prime Minister Andrej Babis’ minority government finalized the 2019 draft budget on 19 September, prioritizing increased spending in investments, pensions and public sector salaries; nonetheless, it targets a smaller deficit compared to 2018’s. Babis will need backing from the Communist Party yet again for parliamentary approval, after their support enabled his government’s survival of the confidence vote in July.

The economy is expected to lose steam this year and next. However, the pace of growth should remain robust thanks to healthy household spending gains, underpinned by a nearly-exhausted labor market and brisk wage growth, as well as by planned increases in government spending, particularly higher infrastructure investment. Heightened uncertainty and potential spillover effects from deteriorating global trade conditions cloud the outlook due to the export-oriented nature of the country’s industrial base. FocusEconomics Consensus Forecast panelists see GDP growing 3.2% in 2018 and 3.0% in 2019, which is unchanged from last month’s projection.

ROMANIA | Deteriorating fiscal metrics bode poorly for overheating economy

Detailed data shows that GDP growth inched up in the second quarter, sustained by a robust expansion in consumer spending and a less negative contribution from the external sector. That said, the increase in private consumption was the weakest since Q4 2016. Moreover its pace of expansion decelerated for the third consecutive quarter, while fixed investment contracted, highlighting serious difficulties in the absorption of EU funds. Meanwhile, available figures for the third quarter suggest the economy has shifted into a lower gear from the impressive growth rates recorded in 2017. The healthy but decelerating retail sales growth in July indicates consumer spending has likely continued to increase, supported by a tight labor market but eroded by stubbornly high inflation. In the same month, construction output plunged in annual terms, which bodes poorly for fixed investment. Moreover, data for January–August shows that the budget deficit ballooned from last year, making negotiations with the European Commission on deficit containment more difficult.

Growth will decelerate further next year, restrained by cooling consumer spending and government sluggishness in using EU funds. Unless measures to reduce fiscal and current account deficits are taken, they will add to economic and financial instability in case of capital outflows stemming from the Fed tightening cycle and financial turbulence in emerging markets. FocusEconomics panelists expect growth of 3.9% for 2018 and 3.5% in 2019, down 0.1 percentage points from last month’s forecast.

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HUNGARY | EU triggers Article 7 against Orban’s government

The economy continued to fire on all cylinders in the second quarter, as an extremely tight labor market and robust wage growth spurred consumer spending, while rising EU funds buttressed fixed investment. Q2’s drivers of growth likely remained in place in the third quarter: In July, retail sales continued to soar, underpinned by significant wage growth and an extremely low unemployment rate; industrial production growth accelerated; and construction output surged for the second consecutive month, probably benefiting from the government pre-financing of EU-funded projects. In the political arena, on 12 September, the European Parliament voted to trigger Article 7 of the EU treaty against Hungary on the grounds that Prime Minister Viktor Orban’s government was undermining civil rights, democracy and the rule of law in the country. The procedure could lead to sanctions including the suspension of Hungary’s EU Council voting rights, although most analysts see this as unlikely considering it would require unanimous support from all other EU members. Orban, backed by a relatively high approval rating, announced it will contest the vote at the European Court of Justice.

Growth is set to slow but remain robust next year, boosted by resilient domestic demand. Moderating wage increases will lead to some softening in consumer spending growth, while fixed investment should continue to expand at a healthy but slower pace due to rising interest rates. The main downside risks stem from capital outflows resulting from the Fed’s tightening cycle and shrinking EU funding following European Commission reports of financial irregularities. FocusEconomics panelists see the economy expanding 4.2% in 2018 and 3.2% in 2019, up 0.1 percentage points from last month’s forecast.

MONETARY SECTOR | Inflation edges up in August

According to a comprehensive estimate produced by FocusEconomics, inflation rose in August. Regional inflation came in at 2.8%, up from July’s 2.7%. Stronger inflationary pressures were recorded in five economies, including in the Czech Republic and Romania. A preliminary estimate suggests that inflation ticked back down a notch in September.

Upbeat consumer spending and rising fuel costs have stoked inflation this year, pushing a handful of central banks to begin unwinding their ultra-accommodative positions. In September, the Czech National Bank hiked interest rates for the third meeting in a row. In Hungary and Poland, however, policymakers stayed put amid moderating growth prospects and within-target inflation.

Inflation is seen broadly stable over the short-term, averaging 2.6% in 2018 and 2.5% in 2019, both unchanged from last month’s forecast.

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Christopher Thomas

Economist