Economic Snapshot for South-Eastern Europe

July 4, 2018

Economic growth is significantly stronger than expected in Q1, but signs point to a slowdown in Q2

South-Eastern Europe’s (SEE) economy expanded 5.5% in the first quarter, according to a comprehensive estimate by FocusEconomics. This is markedly above last month’s estimate of 4.6%, and the revision was largely driven by significantly faster-than-expected growth in regional powerhouse Turkey. However, Q1’s figure was still below the 5.8% growth recorded in the final quarter of last year.

GDP in Turkey grew 7.4% year-on-year, as the economy continued to benefit from hefty government stimulus in place since last year. The reading overshot market expectations and was driven by private consumption and fixed investment in construction and machinery. While domestic demand surged, the external sector subtracted substantially from growth, as the country took in far more imports.

Recent figures show that several smaller countries also posted robust growth rates in the first quarter. Growth in Albania picked up notably from Q4 on solid manufacturing and electricity sub-sectors and a tighter labor market, while the Kosovan economy benefitted from healthy infrastructure spending and strong private expenditure. In addition, growth in Montenegro accelerated on a surge in fixed investment. On the other hand, Macedonia’s economy virtually flatlined in Q1 on a contraction in government consumption.

Although the region’s economy held up surprisingly well in the first quarter, available indicators point to a substantial moderation in the second quarter. This is chiefly due to worsening dynamics in Turkey, which is showing signs of strain from the government’s sustained stimulus drive. The country’s manufacturing PMI was in contractionary territory throughout the second quarter, while business confidence has gone south rapidly over the last few months, likely dampened by political uncertainty and heightened exchange rate volatility. Growth in Serbia also likely ebbed slightly in the second quarter on a less favorable base effect, although underlying momentum should have remained solid. In contrast, the economic fortunes of regional powerhouse Romania appear to have improved somewhat, as temporary factors which held back growth in Q1 fade; this view is supported by solid April industrial production and retail sales figures.

On the political scene, Turkish President Recep Tayyip Erdogan and his Justice and Development Party (AKP) triumphed in presidential and parliamentary elections held on 24 June. The victory cements the move to a presidential system of government that gives Erdogan far-reaching new powers. Although political uncertainty has now diminished, it remains to be seen whether the president will heed the warnings of investors and take his foot off the fiscal pedal to prevent a dangerous overheating of the economy.

Meanwhile, in mid-June Macedonia and Greece reached a provisional agreement over a name dispute which has dragged on for decades. The deal still faces opposition from nationalist elements in both countries, and it must be approved by Macedonian citizens in an autumn referendum before the change is written into the country’s constitution. If the agreement holds together, it would mark a sea change in Macedonia’s diplomatic relations and pave the way for EU accession.

 See the Full FocusEconomics South-Eastern Europe Report

Growth should be robust this year despite deceleration from a stellar 2017

The regional economy is seen expanding 3.7% this year, down 0.1 percentage points from last month’s projection and well below the 5.8% expansion recorded in 2017. This is largely because growth in Turkey and Romania is set to slow from unsustainably high levels as the impact of expansionary fiscal policy gradually fades and tighter credit conditions hit private consumption and investment. On the other hand, growth in Serbia is seen accelerating on a looser monetary stance and past reforms which should spur private investment. In addition, the Greek economy should continue to gain momentum this year on a solid external sector, although nominal GDP will still be significantly below its pre-crisis levels. Elsewhere in the region, stronger absorption of EU funds across the Balkans, resilient external demand and improving tourist arrival numbers should support economic activity. The regional economy is expected to expand 3.3% in 2019.

The lower regional GDP forecast for 2018 largely reflects a downgrade to Turkish growth projections, as panelists become increasingly concerned about economic imbalances. Romania had its growth forecast downgraded this month too, as higher inflation will likely dampen consumer spending, while sizeable twin deficits and political uncertainty could weigh on investor sentiment. Macedonia’s GDP forecast was also revised down, while Serbia and Montenegro received upward revisions. The region’s remaining economies saw their projections unchanged.

Despite receiving further downgrades this month, the economies of regional heavyweights Romania and Turkey are still expected to grow at the fastest rates in the region this year on the lingering impact of fiscal stimulus, with both expected to expand 4.2%. At the other end of the spectrum, Greece is projected to record the weakest expansion in the region, at 1.9% growth.

TURKEY | Erdogan is re-elected, and inherits an economy losing steam amid uncertainty over fiscal and monetary policy

President Erdogan was re-elected in the 24 June elections and will now enjoy sweeping new powers, while his AK party—together with its junior partner the MHP—obtained an absolute majority in parliament. This came against the backdrop of an economy losing momentum: Industrial production growth slowed in April, the manufacturing PMI was in negative territory throughout Q2, and business confidence worsened for the third straight month in June. In addition, signs of economic imbalances are becoming glaring. The hefty current account deficit broadened further in April, while inflation is firmly in double-digits and the lira is down sharply since the start of the year. However, the economy performed better than expected in the first quarter, thanks to booming domestic demand. Private consumption surged on higher wages and lower unemployment, while fixed investment was robust, particularly in construction and machinery and equipment. The external sector contracted markedly from growth, however, on soaring imports and stagnant exports.

The economy should lose steam this year after performing above potential in 2017, as credit growth eases amid tighter financial conditions, and higher oil prices push up the import bill and weigh on domestic demand. Exchange rate volatility, geopolitical tensions, a gaping current account deficit and elevated inflation pose downside risks. FocusEconomics panelists expect growth of 4.2% this year, which is down 0.1 percentage points from last month’s estimate. They see growth of 3.6% in 2019.

See the Full FocusEconomics South-Eastern Europe Report

ROMANIA | Growth likely picked up in Q2, although overheating risks are rising as political uncertainty simmers

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.

BULGARIA | Growth revised up slightly for Q1, second-quarter indicators paint a nuanced picture

Comprehensive data put growth in the first quarter at 3.6% year-on-year, a notch above both the preliminary estimate and growth in the fourth quarter last year. Leading the first-quarter expansion was a jump in investment, which benefited from upbeat business sentiment and EU-linked capital spending in the quarter. Externally, the blocwide slowdown did not noticeably restrain exports, which posted solid growth in the quarter. Available data for the second quarter has been mixed; a remarkable decline in the unemployment rate corroborated strong retail sales and improving consumer sentiment, although households likely felt the pinch of higher inflation. On the other hand, industrial gains have been inconsistent in recent months—and output most recently lost ground on an annual basis in April. As it stands, the country’s eventual adoption of the euro was delayed following the ECB’s warnings in June ahead of Bulgaria’s application to the ERM-II. Bowing to the ECB’s preconditions, Bulgarian officials now expect to apply to both the EU’s banking union and the ERM-II sometime in the next year.

Household spending will benefit from a tight labor market and public-sector wage hikes this year, although inflation is expected to eat into gains somewhat. Heavy EU-funded outlays will prop up investment, which will be further supported by the improving business climate and low interest rates. Sound fiscal policy is expected to attract stronger FDI inflows. FocusEconomics Consensus Forecast panelists expect the economy to grow 3.6% in 2018, unchanged from last month’s forecast, and 3.3% in 2019.

CROATIA | Tourism and private consumption are driving growth so far this year

Available data points to the continued strength of domestic demand in Q2, which had underpinned the solid economic expansion logged in Q1. Healthy retail sales growth in April, supported by a tightening labor market and robust gains in real earnings, and record-high consumer optimism in May suggest private consumption remained buoyant in Q2, despite the recent pick-up in inflation. Furthermore, the all-important tourism industry—which accounts for nearly 40% of exports—remains vibrant, with tourist arrivals up by double-digits year-on-year in January–April, hinting at a new record-breaking season this year. Meanwhile, the creditors of the highly-indebted conglomerate Agrokor reached a draft debt settlement agreement on 19 June, whereby the biggest single creditor, Russia’s Sberbank, would become the largest shareholder with a nearly 40% equity stake. Creditors will vote on the deal on 4 July; a two-thirds majority, which is widely expected, is required for the vote to become valid.

Economic activity should remain strong this year, buttressed by a dynamic tourism industry, which is a key source of employment and export revenues; and robust consumer spending, supported by the steady growth of real earnings and falling unemployment. Absorption capacity of EU funds is also set to improve, boding well for capital spending. Although a disorderly restructuring of Agrokor is unlikely, it remains a risk to the outlook. FocusEconomics panelists project GDP growth of 2.7% in 2018, unchanged from last month’s forecast, and 2.7% again in 2019.

INFLATION | Inflation rars up in May

In May, regional inflation rose from 6.8% in April to 7.8%, largely due to higher inflation in Turkey as the weaker lira and strong domestic demand continued to fan price pressures. Inflation also rose in Romania, on higher energy prices and wages, and a loose fiscal stance. Other regional powerhouses Croatia, Bulgaria and Serbia also saw price pressures build, likely linked to the recent surge in crude prices and robust domestic activity.

In early June, the Central Bank of the Republic of Turkey (CBRT) hiked its one-week repo rate from 16.50% to 17.75% in a bid to stem the depreciation of the currency and rein in inflation. In contrast, Albania’s Central Bank lowered its main policy rate from 1.25% to 1.00%, due to the recent strengthening of the lek and below-target inflation.

Inflation in the SEE region is expected to average 7.4% this year, a significant upward revision from last month’s 6.7%, mainly on higher expected inflation in Turkey and Romania. In contrast, inflation forecasts for Albania and Cyprus were cut this month. In 2019, regional inflation is expected to moderate to 6.6%.

See the Full FocusEconomics South-Eastern Europe Report

Oliver Reynolds

Economist