Central & Eastern Europe Economic Outlook September 2016

CEE economy picks up in Q2; political uncertainty persists

Central & Eastern Europe: CEE economy picks up in Q2; political uncertainty persists

September 7, 2016

The economies of Central and Eastern Europe (CEE) regained some momentum in the second quarter of the year after Q1’s slump. Regional GDP growth sped up from 2.9% in Q1 over the same period last year to 3.3% in Q2, mainly due to solid growth in private consumption. The acceleration was supported by many of the conditions that have been fueling growth for several quarters now, including improvements in the labor markets, subdued inflationary pressures, accommodative monetary policy and fiscal loosening. At the same time, Q2’s reading highlighted the continued deterioration in fixed investment across the region, which had started in Q1 as EU development funds faded.

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Political uncertainty remains elevated in Q3, as worries surrounding the implications of the Brexit vote and politics in the CEE region persist. The Brexit vote will likely drag on confidence and might contribute to a further weakening of investment, which has already been declining due to lower inflows from EU funds. In Poland, contentious political policies have been hitting investor sentiment and the country’s standoff with the EU over democratic backsliding continued in August when the EU increased pressure on Poland’s government to address rule of law concerns. Adding to this, the fiscal stimulus measures envisaged in Poland’s 2017 draft budget, which include lowering the retirement age and lifting public wages, bear the risk of fiscal slippage.

The region also faces a hefty election calendar in the coming months, adding to political uncertainty. Croatia will hold snap elections on 11 September after the Parliament was dissolved due to infighting within the government coalition. Recent polls point to a hung parliament and risks of reform standstill are high as Croatia’s two main parties have promised tax cuts and toned down their talk of tough but necessary reforms. Romania will also head to the polls by year-end, and any delays over forming a government could threaten reform momentum in one of the region’s top performers. On top of this, Lithuania will hold parliamentary elections on 9 October. Against this tumultuous backdrop, the region’s growth is expected to recede in Q3 to 2.9%. 

CEE’s growth outlook stabilizes

The economic growth prospects for Central and Eastern Europe stabilized this month following last month’s downward revision. Q2’s GDP readings suggested that overall the region had proved more resilient than expected to declining investment funds from the EU and sluggish growth in the Eurozone, as solid private consumption partly helped to balance these headwinds. This fueled expectations that solid household spending—which is boosted by rising wages, falling unemployment as well as fiscal and monetary stimulus—will support robust growth in the region, despite substantial weakness in fixed investment. Nevertheless, subdued sentiment in the aftermath of the Brexit vote and the expected slowdown in the Eurozone still represent significant downside risks to the outlook. Panelists surveyed by FocusEconomics project a 3.0% expansion in 2016, which is unchanged from last month’s forecast. Next year, our panel foresees steady growth of 3.0%.

This month’s outlook reflects stable growth prospects for 4 of the 11 economies surveyed, including the Czech Republic and Slovakia. Adding to this, upward revisions in four economies, including Hungary and Romania, broadly countered downward revisions in Latvia, Lithuania and major-player Poland. 

Romania will likely be the region’s fastest-growing economy this year, with an expected expansion of 4.5%. Poland and Slovakia are also seen achieving fast growth rates of 3.2%. On the other side of the spectrum, Croatia, Estonia, Hungary and Slovenia are expected to be the CEE region’s laggards, with expected expansions of 2.0%. 

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CZECH REPUBLIC | Booming external sector supports growth

Revised data confirm that the Czech economy decelerated in Q2, although growth remained healthy. GDP expanded 2.6% on an annual basis, coming in below the 3.0% increase recorded in Q1, mainly due to a contraction in fixed investment. The sharp drop in fixed investment mainly derives from the fact that, while in 2015 fixed investment surged strongly on the back of increased absorption of EU funds, this year EU funds dried up substantially. On the upside, the external sector continued to be a bright spot, as its contribution to growth increased and hit an almost-five-year high. Survey-based data for Q3 sent cautiously positive signals. In August, the Manufacturing PMI rebounded to positive territory after having dropped into contractionary territory in July for the first time since April 2013. In the same month, economic sentiment improved and hit a six-month high, reflecting an improvement in both business and consumer confidence but nevertheless staying below its long-term average.

The economy will decelerate this year due to declining investment, but will nonetheless record a healthy pace of growth on the back of solid private consumption and buoyant exports. The possible Brexit-induced slowdown in the EU economy poses some downside risks to growth. Panelists see GDP growth moderating to 2.5% in 2016, which is unchanged from last month’s forecast. For next year, they see growth ticking up to 2.6%.

HUNGARY | Economy recovers in Q2 and prospects for fiscal stimulus support outlook

Broad-based improvements helped Hungary’s economy to shrug off Q1’s weakness and regain momentum in Q2. Annual GDP growth increased from 0.9% in Q1 to 2.6% in Q2 as expansions in services, industrial production and agriculture more than offset feeble construction—which shrank as EU development funds have been dwindling since the beginning of this year. However, August’s drop in economic sentiment to a two-year low suggests that the upturn will likely not be sustained in Q3. In the medium-term, a new round of fiscal stimulus will likely support growth: Economy Minister Mihály Varga announced in August that a fiscal package will be unveiled in the fall. According to media reports, planned measures include a labor market reform and cuts in social taxes paid by employers.

Growth this year will fall short of last year’s outstanding result as EU funding dries up. Healthy private consumption, which is boosted by a buoyant labor market and fiscal and monetary stimulus, will nevertheless still drive a robust expansion. Following the release of Q2’s stronger-than-expected expansion, our panelists revised up Hungary’s GDP growth forecast for this year by 0.1 percentage points. They now see the economy expanding 2.0% in 2016, while for 2017 they project a 2.6% expansion.

POLAND | Feeble investment limits pickup in Q2, increased uncertainties restrain growth prospects

The Polish economy grew 3.1% in annual terms in the second quarter, accelerating slightly over Q1’s 3.0% increase. The mild improvement in Q2 came on the back of stronger private consumption and robust external demand. On the downside, fixed investment contracted at a sharper pace, dragged down by the reduction in EU development funds. Data for the third quarter sent positive signals: business confidence improved in August after deteriorating in July, and the manufacturing PMI improved in the same month. On 25 August the government presented the draft budget for 2017, which foresees a fiscal deficit of 3.1% of GDP. Therefore, the country appears at risk of breaking the EU’s 3% deficit rule due to the proposed government stimulus actions, including a lower retirement age, an increase in public wages, free medicines for senior citizens and more security spending.      

Poland’s economy is expected to decelerate somewhat this year, on the back of weaker fixed investment. In addition, Brexit-related spillovers on investment and exports pose downside risks to growth. The FocusEconomics panel sees GDP expanding 3.2% this year, which is down 0.1 percentage points from last month’s projection. For 2017, the panel sees economic growth of 3.3%.

See the Full FocusEconomics Central and Eastern Europe Report

ROMANIA | Growth surges in Q2

In Q2, the Romanian economy grew at the fastest pace since Q3 2008. GDP grew 6.0%, up from a 4.3% expansion in Q1, making Romania the fastest-growing economy of the quarter in the region. Domestic demand likely remained the main driver of growth thanks to the government’s aggressive expansionary fiscal policy in the run-up to this year’s parliamentary elections. Tax cuts and public sector wage hikes have caused double-digit increases in average wages, leading to a consumption spree evidenced by strong retail sales growth over the past year. However, the pre-electoral fiscal package also risks increasing the country’s vulnerability to external shocks: after the government had reined in both the fiscal and current account deficits in recent years, the current account recorded its largest deficit in over three years in Q2, while the budget shortfall is expected to fall just within the EU’s upper limit of 3.0% this year. On the political front, the government confirmed this year’s parliamentary elections for 11 December.

Domestic demand will remain the engine of growth this year, but the outlook remains vulnerable to an adverse external environment: along with Brexit-related uncertainties, the fallout from the attempted coup in Turkey has already negatively affected Romanian exports to Turkey, its largest non-EU trading partner. Panelists expect the economy to grow 4.5% this year, which is up 0.3 percentage points from last month’s forecast. In 2017, the panel foresees economic growth moderating to 3.5%.

INFLATION | Consumer prices stable in July

Consumer prices continued to decline in annual terms in most economies of the CEE region in July, as low oil prices persisted. According to an estimate elaborated by FocusEconomics, divergent price developments across the countries overall offset each other, and in the CEE region as a whole, consumer prices fell 0.5% in July over the same month of last year, which was in line with June’s drop. While prices remained at historic lows in most countries, four of the region’s economies recorded inflation in July.

Price pressures will likely remain muted throughout this year and only increase very gradually. The panelists polled this month by FocusEconomics expect that consumer prices will drop an annual 0.2% in 2016, which is down 0.1 percentage points from last month’s projection. This month’s outlook reflected downward revisions to the inflation forecasts for four countries in the region, including the regional heavy weight Poland. The inflation outlook for all remaining countries in the CEE region was stable compared to the previous month. Analysts expect that inflation will return to the CEE region next year, forecasting average inflation of 1.6%.

See the Full FocusEconomics Central and Eastern Europe Report

Written by: Angela Bouzanis, Senior Economist

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