Central & Eastern Europe July 2018

Central & Eastern Europe: First-quarter growth eases as external demand wanes

July 3, 2018

More comprehensive data revealed that the Central and Eastern European (CEE) economy lost steam in the first quarter on the heels of a breakneck growth spurt last year. Growth in the region clocked in at 4.4% annually in the first quarter, down a notch from last month’s estimate and notably slower than the 4.9% expansion recorded in the fourth quarter of last year. By all accounts, however, growth in Q1 was still healthy; the CEE economy has been experiencing rapid homegrown expansions in both consumer spending and fixed investment amid labor shortages and cheap financing, respectively. Moreover, stronger absorption of EU development funds has brought about an investment boom in much of the region. On the flipside, however, a slowdown in the Eurozone hit the region’s external sector at the outset of the year as demand waned for CEE-originating wares.


Poland, the region’s largest economy, posted one of the strongest outturns of the past decade as the tight labor market fueled strong wage gains. Moreover, investment jumped on increased absorption of EU funds and a nascent construction boom. Bulgaria also posted stronger first-quarter growth on heavier capital outlays. Meanwhile, a second estimate confirmed similar dynamics in Hungary in the first quarter; matching the previous quarter’s solid pace, the domestic-driven expansion saw both consumer spending and investment jump.


In the political arena, the Czech Republic could soon see the end of political gridlock as coalition plans are set to be voted on in parliament on 11 July. After more than eight months under a caretaker government following last October’s elections, and a failed confidence vote on forming a minority government in January, Prime Minister Andrej Babis’s ANO party agreed to build a coalition with the center-left Social Democrats (CSSD). As a proposed ANO-CSSD coalition would not secure a majority of seats in government, the coalition is set to rely on support from the Communist party in the confidence vote; the Communist party has agreed in principle after pushing for a number of concessions.


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Healthy labor market should drive solid growth this year


Low unemployment, upbeat wage growth and the ongoing surge of domestic and EU-linked investment are expected to drive another strong outturn for the CEE economy this year. That said, regional growth is seen ticking down from last year’s one-decade high as demand from the Eurozone, the region’s largest trading partner, cools. Moreover, the impact of earlier fiscal stimulus measures is expected to increasingly fade, and rising inflation could take a bite out of consumption. All told, regional growth is seen clocking in at 4.0% this year, up 0.1 percentage points from last month’s forecast. Regional growth is seen easing to 3.3% next year.


Deteriorating global trade relations are increasing risks to the CEE economy’s growth trajectory. In late June, U.S. President Donald Trump proposed implementing tariffs on European Union-built automobiles, an escalation to a tit-for-tat tariff conflict following the U.S.’s imposition of tariffs on aluminum and steel. If implemented, the tariffs could stifle one of the region’s most important industries.


Poland and Hungary, two of the region’s major players, saw their 2018 growth forecasts revised upward in July on the heels of solid first-quarter outturns. On the other hand, Romania and Estonia saw their full-year prospects downgraded this month following disappointing starts to the year. Meanwhile, 7 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—is expected to grow at below 3.0%.


POLAND | Tensions with Brussels grow as judicial reforms come into effect


Available data for the second quarter has been uneven, hinting that growth could be slowing on the heels of an exceptional first-quarter outturn. Household spending appears set to post solid gains in the quarter despite rising inflation; unemployment ticked down through May, sending retail sales higher. Meanwhile, industrial gains recovered somewhat from a weak end-first quarter, due in part to robust manufacturing output. That said, slower growth across Europe, as well as higher input costs due to the weak zloty, has been weighing on manufacturers. In the ongoing standoff between Warsaw and Brussels, in early July, Polish officials were set to enact sweeping judicial reforms into law against protests from the EU. Tensions have risen as the upcoming 2021–27 EU budget increasingly takes shape. European lawmakers have escalated their rhetoric on reallocating more than a quarter of the country’s cohesion funding, which could delay passage of a blocwide budget into next year.


Tight labor market dynamics and rapid wage growth will support strong consumer spending this year, while fixed investment will benefit from EU-linked funding inflows, upbeat business sentiment and a nascent construction boom. Export growth, meanwhile, is set to moderate somewhat as European demand cools. Fiscal slippage ahead of next year’s elections is likely to widen the deficit, while growing uncertainty over the next EU budget is hanging over the long-term outlook. FocusEconomics analysts expect growth of 4.3% in 2018, up 0.1 percentage points from last month’s forecast, and 3.4% in 2019.


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CZECH REPUBLIC | New coalition seeks to end political stalemate with 11 July confidence vote


Available indicators point to more upbeat economic activity in Q2, following the slowdown in Q1 that was largely attributable to soft external demand. Industrial production rebounded strongly in April on the back of an impressive jump in vehicle manufacturing, significantly contributing to the double-digit growth of goods exports that same month. On the domestic front, an extremely tight labor market—the unemployment rate fell to a new all-time low in May—and public and private sector wage hikes have shored up households’ real incomes, which, coupled with record-high consumer confidence throughout the quarter, suggest the continuation of robust private consumption growth in Q2. Meanwhile, on the political scene, President Milos Zeman appointed a new two-party cabinet, led by Prime Minister Andrej Babis, on 27 June. This came after the Social Democrats voted on 15 June to join Babis’ ruling ANO party in a coalition government, potentially putting an end to more than eight months of political stalemate. The minority government would have to rely on support from the Communist Party, which is expected, to survive the mandatory vote of confidence set for 11 July.


Although economic growth is seen slowing this year, it should remain robust. Household consumption, buoyed by a tight labor market and expansionary fiscal policy, should underpin overall economic activity. A slowdown in EU demand and potential U.S. tariffs on German vehicles, however, could hit the key industrial and export sectors, weighing on the external sector’s contribution to growth. FocusEconomics Consensus Forecast panelists see GDP growing 3.5% in 2018, which is unchanged from last month’s projection, and 3.0% in 2019.


ROMANIA | Bond yields hit four-year high amid overheating and political volatility


Economic activity slowed sharply in the first quarter but likely regained some speed in the second quarter. Soaring inflation and rising interest rates dragged heavily on private consumption in Q1, leading to a marked slowdown in GDP growth. However, strengthening retail sales and industrial production in April and the low unemployment rate in both April and May suggest activity accelerated in Q2. On the other hand, surging inflation and widening fiscal and current account deficits are clear signs of overheating. In early June, the IMF warned the government to tighten its fiscal policy and moderate wage increases to guarantee more sustainable and balanced growth. Meanwhile, the political scene remains tense. On 27 June, parliament rejected a no-confidence motion against the government. The motion was presented by the opposition after the powerful leader of the ruling Social Democratic Party, Liviu Dragnea, was sentenced to over three years in jail for abuse of office. Due to political volatility, the 10-year bonds yields reached an over four-year high in late June, and investor sentiment could be further hit going forward.


Growth is expected to moderate notably this year. Despite ongoing fiscal stimulus, faster inflation will weigh on household spending. Moreover, an inefficient absorption of EU funds will likely restrain fixed investment growth, which will nevertheless accelerate from last year. Large fiscal and current account deficits represent clear downside risks. FocusEconomics panelists expect growth of 4.2% for 2018, down 0.2 percentage points from last month’s forecast, and 3.6% in 2019.


HUNGARY | Next year’s proposed budget to improve fiscal profile as economy cruises into H2


The economy continued to fire on all cylinders in the first quarter, and momentum likely carried over into the second quarter. GDP growth in Q1 was boosted by buoyant domestic demand, while the external sector weakened on cooling demand from the EU. Heading into Q2, data for April shows that retail sales continued to expand at a solid pace, benefiting from extremely tight labor market conditions. Moreover, industrial production accelerated somewhat, supported by a rebound in exports, and lending growth remained healthy. In mid-June, the finance minister submitted the 2019 budget to parliament. It includes a cut in social security charges and further hikes in public sector wages, and forecasts a reduction in both the fiscal deficit and public-debt-to-GDP ratio. Meanwhile, on 20 June, the parliament approved legislation that makes certain forms of help to migrants a criminal offence and prevents them from settling in Hungary, in clear defiance of European authorities.


Growth is set to be robust this year, as rising inflows of EU funds, lower corporate taxes and a buoyant construction sector spur fixed investment, while sustained wage growth and stimulus budget measures buttress household spending. Strong domestic demand and weaker foreign sales should, however, lead the current account surplus to narrow. A key downside risk stems from potential capital outflows following rising global interest rates. FocusEconomics panelists see the economy expanding 3.9% in 2018, up 0.1 percentage points from last month, and 3.1% in 2019.


MONETARY SECTOR | Inflation ticks up in May as fuel costs rise


According to a preliminary estimate produced by FocusEconomics, inflation climbed for a third straight month in May to land at 2.6% (April: 2.4%). Higher prices were recorded in all but 1 of the region’s 11 economies, namely Slovakia. Across the region, inflationary pressures have been building in line with this year’s rapid rise in global oil prices. Improving consumer spending dynamics throughout the CEE economy have also lent upward support. Preliminary data for June puts inflation at 2.7%, again ticking higher on rising fuel costs.


Despite this year’s steady rise, still-low inflation has given policymakers in the region room to keep their respective monetary policies accommodative. By and large, the region’s central banks appear set to put off their tightening cycles until necessary in the interest of spurring the ongoing investment boom. In Poland and Hungary, inflation remains below the midpoint of each central bank’s target, which pushed officials to leave rates unchanged at their June meetings. Meanwhile, in the Czech Republic, inflation exceeded the CNB’s 2.0% target in May, prompting officials to hike the policy rate by 25 basis points.


Amid ascending pump prices and robust consumer-spending gains, inflation across the CEE economy is seen averaging 2.5% this year, unchanged from last month’s forecast. Next year, inflation is seen stable at 2.5%.


See the Full FocusEconomics Central and Eastern Europe Report


 


Christopher Thomas


Economist


 


 


 

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