Central Europe sheltered by EU despite fading funding

Central Europe sheltered by EU despite fading funding
By bne IntelliNews December 22, 2015

The Eurozone may not be top of everyone's Christmas card list right now, but the economies of Central Europe will continue to follow the bloc religiously.

Although sluggish, the recovery in the EU looks set to continue to offer the Visegrad economies protection. Export demand from the Eurozone has helped the Czech Republic, Hungary, Poland and Slovakia shrug off the challenges presented by weak emerging markets and Russian sanctions in 2015. However, it was a bloc bonus that boosted them into overdrive, and it won't be around in 2016.

With the EU's 2007-13 funding window finally shutting at the end of the year, the four states spent 2015 scrambling to hoover up as much EU aid as possible. Analysts suggest the frenzy – a contrast to the usual poor rate of absorption among the Visegrad group – enabled countries in the region to take in the equivalent of 2.5-3.5% of GDP in the first half of 2015.

Hungary, for instance, said in early December it had taken in close to 100% of funding available from the seven-year EU budget. That means the country absorbed over HU9tn (€28bn), which has been used to power state investment while still allowing the government to cap debt and deficit levels.

It's a similar story across the region. However, EU funding volumes are about to fall off a cliff. The start of disbursement under the 2014-2020 window will likely mean that Central Europe will resume its previous slothful habits.

For most CE states, the funds available under the new window are typically smaller than in the 2007-13 programme period when measured as a share of GDP. The IMF has also suggested that the recent sprint to draw down unused funds has knocked back preparations for receiving funds from the new window.

In a best case scenario, Capital Economics estimates Hungary and the Czech Republic could face income falls of around 1% of GDP in the coming year. EU funds "are not, and are unlikely to be, the primary driver" of growth, Capital Economics stresses, but the drop will clearly impact on the economies in the region.

In short, growth looks set to pull back, or stagnate at the very least. Given recent data, the IMF's 3.6% forecast for Hungary in 2015 looks ambitious, and the same could be said of the 3% prediction for 2016. Slovak growth looks set to come in 10 or 20 basis points above 3% in both years; Poland is likely to follow a similar holding pattern but at around 3.5%.

The Czech Republic is set to put in an EU-leading performance in 2015, with GDP growth likely to cross the 4% threshold. However, it's set to come down with a bump in 2016.

"GDP growth is forecast to decelerate to sub-3% during 2016-17 as the [EU fund driven] investment boom fades," notes Commerzbank "The direction of surprise will depend on economic momentum in the euro area," add the analysts.


Indeed, it's not just structural funding that the EU brings to the Visegrad table. The slow but steady recovery in the Eurozone has helped insulate the region from the slowdown in emerging markets in 2015. Yet Eurozone growth remains anaemic. Deutsche Bank is largely in line with consensus in predicting a 1.5% gain in Eurozone GDP in 2015, and the bloc is unlikely to grow much faster the following year.

That's still been enough to ensure the struggles in large emerging markets such as Russia and China have left Central Europe largely unscathed for the meantime. That's a particular achievement given depressed car sales earlier in the year in China – the world's biggest market – and Russia amongst others. Autos are the big ticket export item in Visegrad, which has made the emissions scandal at Volkswagen another particular risk.

However, the signs are that Central Europe's car factories – many directly owned by the German giant – have successfully shrugged off the dangers. In fact, production in the region has soared throughout the year.

But like the EU funds, that boost may not last long into 2016. Visegrad's role in the German supply chain drives a huge chunk of the region's GDP. Industrial output in Germany is likely to remain flat in 2016, according to Deutsche Bank, as economic and geopolitical risks cap export growth. As the boost from the weak euro wears off, declining demand in spots such as China and Russia is likely to limit expansion in the country's auto industry to 0.5%.

Like Germany then, while exports should provide a reasonably solid base for the Central European economies, it will be largely left to domestic demand – and household consumption in particular – to provide the growth in 2016. Following an impressive year in 2015, labour markets are expected to continue to tighten, driving a consumption boost.

Private consumption in Slovakia is estimated by Erste to have swelled by 2% in 2015. The Austrian bank expects that to grow a further 2.8% in the following year. Predictions for the rest of the Visegrad region are in similar territory.

On top of more jobs and higher wages, the lack of inflation has also pushed consumption. As energy importers, the Central European countries have been benefiting from the collapse of oil prices. However, while price falls have helped drive domestic demand, it's unclear if that boost will last through 2016. Inflation is expected to return across the region, albeit price rises will likely remain limited.

That is set to keep monetary policy loose. The European Central Bank has recently extended its quantitative easing programme and dropped rates further in a bid to shore up the Eurozone's fragile recovery. That all but dictates a similar stance in Central Europe. In fact, further loosening is possible in Poland and Hungary, despite the current record low interest rates, in particular if the economies start to sag or inflationary pressure refuses to return.

On top of that, government and fiscal policy is also likely to offer more support. The new PiS government in Poland is set to introduce social spending measures that should "provide stimulus to GDP growth in the short term”, Erste points out. "Domestic demand should be the pillar of that growth."

The looming Slovak election in March 2016 has also led state spending to rise. Bratislava is also placing big hopes in the forthcoming investment in a plant by Jaguar Land Rover, which the government suggests could push GDP growth to as high as 4% in 2016.

Hungary is hoping private investment can rise on the back of its peace deal with the banks and the wall of cheap money across the globe - even if the latter is likely to fall somewhat with the US Federal Reserve moving to raise rates. Lowering the special tax burden on lenders is meant as a sign to investors of all stripes that crisis-driven policymaking is now over. It is also intended to persuade the wary banks to resume lending to the economy.

Meanwhile, there are outliers that could yet impact on the region, mostly negatively and on the geopolitical level. A further deterioration in the West's relations with Russia, or a potential cut in gas supplies – as happened in 2006 and 2009 – could hit the region's economies. Meanwhile, there has already been discussion that the borderless Schengen zone could – though it is unlikely – be suspended.

The latter especially would hurt Central Europe because of its heavy dependence on just-in-time exports to the Eurozone. "Reinstalling border controls could cause severe delays in transportation time, which could have a negative impact on industries depending on just-in-time deliveries," warns Erste.

Aside from the obvious economic dangers, a breakdown in the free movement of people in the EU would spark protests in Visegrad. The region has already seen its image dented in the western half of the EU because of its stance on the migrant crisis, while the issue has accompanied a huge rise in support for nationalist and populist politics, both issues that naturally put investors on edge.

However, for financial market investors, Central Europe is likely to top the list as a safe haven, as uncertainty rocks the wider emerging market asset class. With the resumed oil price collapse in late 2015 "shredding" credit markets, noted analysts at Nomura, Central Europe offers "key strengths". They have limited trade links to China, are energy importers, and have generally reformed to improve their fiscal positions, competitiveness and banking.

Of course, all bets could be off should the worst fears that another shock to the global financial system is on the way pan out. Stressed high-yield US credit funds have analysts fretting that they could be a sign that another credit crunch is on the way.

Faded Czech glory

Returning to growth for the first time in three years in 2014, the Czech economy powered onwards in 2015 to expand at its fastest pace since the onset of the global crisis. GDP grew 4.5% in the third quarter, the second strongest pace in the EU. However, that momentum looks likely to stall in 2016.

Growth in 2015 was mainly driven by domestic demand, with a major contribution coming from increased investment as the government rushes to tap remaining funds under the 2007-2013 programming period. Meanwhile, rising income and low inflation have provided a boost to household consumption.

At the same time, improving demand from abroad is supporting private investment. The central bank’s weak koruna policy has buoyed the key export sector. Net exports, however, are contributing negatively to growth, partly because of the high import intensity of the ongoing investment.

Conditions are in place for household consumption to remain strong next year, but the investment boom will fade as the inflow of EU funds drops. Weaker public investment in 2016 is forecast to weigh on activity, bringing real GDP growth down to 2.2% from an expected 4.3% in 2015, the European Commission wrote in its latest forecast published in early November. Thus, private consumption and any improvement in foreign demand should be the main drivers of growth in 2016.

“Household consumption will be the highest contributor to GDP growth (approximately 1.5pp) in 2016, as it will be supported by a strong labour market and positive sentiment in the Czech economy,” analysts at Erste suggest. Increases in the minimum wage and public sector wages should also support private consumption.

However, the country's heavy dependence on demand out of the Eurozone for exports leaves it vulnerable to any slowdown across the single-currency area. Further than that, the overwhelming weight of the auto sector in the economy makes it susceptible to industrial cycles. Thus, factors that represent risks for the Czech economy are a significant slowdown in the Chinese economy and the Volkswagen scandal.

The potential negative effect of each on GDP growth ranges between 0.1pp and 0.3pp, suggests Erste. “The economic slowdown in the Chinese economy would be “imported’, mainly via lower foreign demand from western European countries, e.g. lower German exports to China would consequently decrease Czech exports of intermediate goods, and then in turn contribute to lower domestic demand in the Czech Republic”, the analysts note.

The exceptionally strong GDP growth, as well as loose monetary conditions, have so far failed to spur price growth in the Czech Republic. Inflation is set to remain below the Czech National Bank’s (CNB) target of 2% to at least the end of next year. Against this backdrop, and taking into consideration the extension of the European Central Bank’s quantitative easing policy beyond 2016, the CNB has signalled it may prolong its CZK27 to the euro cap by yet another six months to 2017.

“We expect CNB to dismantle its EUR-CZK floor mechanism in early 2017, after inflation has returned to within target range”, Commerzbank forecast in early December. The analysts, however, expect the market to continue testing the CNB’s willingness to defend the cap.

“If the floor were to prove problematic to maintain because CNB has to actively intervene … how long will the bank tolerate this? That is the question the market wants to test the CNB with from time to time,” the analysts point out. However, the central bank appears to have few options but to keep the cap in place throughout 2016. The conservative CNB is highly unlikely to move from virtual zero to negative interest rates.

Meanwhile, lower growth in 2016 will offer the government less chance of maintaining the turbo-charged improvement in the deficit, which it targets at CZK70bn. In 2015 it will undershoot the CZK100bn by some distance, going by data available to date. Still, even should the gap come in according to plan, it will equal no more than 1.2% of GDP.

Hungary losing support

Hungary’s economy moved from being the best performer in Central Europe in 2014 to probably the worst in 2015. It's likely to continue travelling in that downwards direction in 2016 as previously supportive factors, mostly state driven, lose strength.

After growing at the exceptional rate of 3.7% in 2014, real GDP growth in Hungary is expected to ease to 2.9% this year, the European Commission forecasts. The slowdown mainly reflects weaker growth in investments.

“Growth figures are heavily influenced by Hungary’s absorption of EU funds, which helped propel investment growth to 11.2% in 2014 and which, after a timid increase this year, may lead to temporarily negative figures in 2016,” the EU executive noted in its latest outlook for the bloc.

Private consumption and the external sector continued to drive growth in 2015 as Hungarian consumers benefitted from rising wages and low inflation. However, the government has also helped out; household finances have benefited from one-off measures, including a reimbursement from banks for illegitimate interest and exchange rate changes on forex mortgages.

Budapest hopes to offer more support in 2016. A 1 percentage point cut in personal income tax to 15% is set to be introduced in January. But as the inflow of EU funds drops, it will weigh heavily on growth. The majority of analysts plot GDP expansion at just above 2% for the coming year.

Further than that, the government's room for manoeuvre is decreasing. The EBRD expects a slowdown to 2.1%, as stimulus from the budget will be increasingly constrained by efforts to improve fiscal indicators in a bid to restore Hungary's investment grade sovereign rating.

Budapest is clearly close to escaping junk after cutting the deficit to below the EU’s threshold of 3% of GDP and gradually relaxing its controversial sectoral taxes. It has amended a controversial advertising tax and pushed through cuts in the high banking levy as of next year, as it tries to persuade lenders to boost credit to the slowing economy. 

“Such developments put Hungary in a strong position for a rating upgrade … during 2016 – Moody’s and Fitch already hold positive outlooks,” Commerzbank suggests.

Inflation is forecast to accelerate in 2016 but the CPI index is not expected to rise towards the central bank’s 3% target until at least mid-2017. That should provide support to the Magyar Nemzeti Bank (MNB) to keep monetary conditions extremely loose, or even ease them further.

The MNB cut its base rate to a record low of 1.35% in July and has said it does not plan to lower it more but to use unconventional tools to relax monetary conditions further. Analysts struggle to agree, however, on whether that guidance can be taken for granted throughout the year.

Polish politics poses questions

Poland’s economy looks to be on track to maintain solid growth in 2016, based on healthy consumption, as well as stable exports and investment. The main domestic uncertainty is just how much the new government will loosen the purse strings.

Inside its first few weeks in office, the ruling Law and Justice (PiS) increased the budget deficit for 2015 and 2016 to fund a programme of social spending. While the credit markets worry over Poland's fiscal course, the boost in spending should only help boost growth in the short term.

“We look for the Polish [yield] curve to steepen, supported by relatively high GDP growth, rising inflation during 2016 and loosening in fiscal policy," BZWBK writes. "We forecast a two-year yield slightly below 1.50% and a 10-year yield of 3.50% at the end of 2016.”

However, on the ground, the real economy is set to benefit; the boost should help domestic demand compensate for a lack of growth in exports and a drop in EU funding. Growth is expected around 3.5% in 2015, and is likely to maintain similar pace across the subsequent year.

Continued strength in consumption growth should lead the way. With the Polish labour market set to continue tightening for a third successive year, the European Commission puts 2016 growth at 3.5%.

BZWBK forecasts private consumption will push to 3% growth. Some negative contribution may come from net exports, but that should be “moderate,” the bank adds.

There is uncertainty, however, over the pace of investment growth. The political noise in Warsaw - PiS has already been accused of trying to trample democracy - and trimmed EU funding, are likely to slow GDP growth according to some.

Private consumption should hold up as a pillar of growth, according to Erste, but as the dynamics of investment decline, the Austrian bank's analysts expect economic expansion to stick at 3.3% in 2016.

At Commerzbank, they expect "the combined effect of a lull in EU structural funding … and continued tepid performance of the Eurozone economy, possibly exacerbated by a Chinese economic slowdown" to produce slower economic growth during 2016-17. "This would be countered," the German bank adds, "to some degree by a 0.1pp-0.2pp expansion in the fiscal stance."

BZWBK, by way of contrast, suggests investment growth could push to 6% in 2016. "We remain quite optimistic about private investment in 2016," the analysts write. "Entrepreneurs are in buoyant mood and plan to invest, capacity utilization is above average and credit criteria are still loose. Public investment may take time to emerge from the current soft patch, but the new EU financial framework and government plan should be supportive."

Growth will likely continue to be accompanied by very mild inflation in 2016. Deflation persisted far longer than originally forecast in 2015; should CPI disappoint again in 2016, the central bank is likely to act, which should also offer another boost to growth, albeit at a cost to the already weakened zloty. The majority of the monetary policy council's 10 members are set to be replaced by March, with PiS clearly favouring dovish candidates.

However, while a rate cut would encourage further demand for credit, the banks claim they may be put off lending by PiS policy. The government already has a tax on the sector ready to roll out in February, which "will significantly weaken the ability to issue loans," the deputy CEO of Pekao claims.

Yet the government says it will be careful not to destabilise lenders. It is currently mulling a delay in plans to force a conversion of Swiss franc mortgages, a move that is forecast to cost the banks at least PLN30bn.

Slovak growth set to brake

Enjoying solid growth in 2015, Slovakia’s economy is expected to continue expanding in 2016, although at a slower pace due to weaker public investment and exports.

Domestic demand will remain the driving force behind growth, with household consumption continuing to accelerate, backed by improving labour market conditions. Measures including a rise in the minimum wage and public sector salaries, a reduction in the social contributions paid by low-income workers, and a 50% cut in the VAT rate on a number of selected food products should also help. The National Bank of Slovakia sees growth in private consumption accelerating to 3.3% in 2016 from 2.2% in 2015.

Public investments, however, will expand more slowly than in 2015, being impacted by lower absorption of EU funds. Despite predicting stable expansion of private investment, the central bank suggests gross fixed capital formation in 2016 will expand by just 2.2%, compared to 9.3% the previous year.

Still, a positive impact on the economy should arrive via a large investment from Jaguar Land Rover in Nitra. The new car plant could boost economic growth to 4%, according to Finance Minister Peter Kazimir.

Most estimates pitch overall growth in 2016 closer to 3%. The central bank recently cut its forecast by 0.3pp to 3.1%; the finance ministry has slashed its outlook by 0.6pp to the same headline figure. The European Commission and the IMF expect 2.9% and 3.2%, respectively.

The JLR investment may indeed be needed to offset potential losses triggered by the Volkswagen emissions scandal. The German carmaker is one of the country’s biggest employers and the top exporter, and has said it will delay or cancel all non-essential projects.

Although the carmaker has not named the investments that will be pulled, the announcement puts questions marks over several planned projects in Slovakia. With the auto sector making up a huge chunk of overall GDP, Bratislava will be watching developments closely.

Exports, the only meaningful driver of economic growth just a couple of years ago, are likely to expand at a slower pace than in 2015. The still fragile recovery in the Eurozone – and especially the manufacturing sector, which drives so much Slovak activity via the supply chain – remains exposed to the difficulties in emerging markets, particularly the slowdown in China. Slovak exports are also at risk from persisting geopolitical tensions, or even the possibility of the return of borders within the Schengen zone.

However, barring new global shocks, Slovak consumer prices should return to growth in 2016. Price rises are likely to remain mild, impacted by continued weak oil prices and a decrease in regulated gas prices for households that took effect in September. The central bank has recently cut its inflation outlook for 2016 to 0.7% from 1.1%.

Slovakia’s target to reduce the budget deficit to 1.93% of projected 2016 GDP from 2.74% in 2015 could be put at risk ahead of general elections scheduled for March. On top of earlier spending programmes that raised the 2015 target, the government recently announced a €1bn package of social and security measures that will be put into force if the ruling Smer party wins elections. Bratislava insists improved tax collection will fund the spending.

General elections will be organised on March 5 and polls show Smer is close to securing a second term with a single-party majority. Recent constitutional amendments and new legislation aimed at increasing the country’s security in the face of claimed terrorist threats will likely only boost support for Smer, while the opposition remains fragmented.

The Baltics

The Baltic states of Estonia, Latvia and Lithuania are united in their fear of Russia, but despite lots of brotherly rhetoric on other matters, their paths look likely to diverge somewhat in 2016.

All three have increased their defence spending in 2015 (though Estonia continues to outperform and remains one of very few Nato member states spending 2% of GDP on defence) and all three are welcoming ever more-powerful rotations of US troops.

After reaching a peak in the middle of 2015, concern about possible covert military Russian action in the Baltics has receded slightly with Putin's attention focused on Syria. However, Vladimir Vladimirovich does have a nasty habit of doubling up on his gambles as he did in eastern Ukraine post-Crimea, and as he is now doing in the Middle East with Donbas turning sour. If he got burned in Syria, the Baltics might provide a suitable distraction.

It might sound far-fetched, but if you had said to anyone here a few years ago that Russia would be flying combat missions in Syria while their planes were being downed by Turkey, not many would have believed you either. Military forces in all three Baltic states are training for ‘Little Green Man’ scenarios. 

Economically, things are a slightly better. According to Danske Bank in December: “The Baltic states are still coping with the negative effects of the Russian food embargo and the general slowdown in the Russian economy. However, signs of the economic bouncing back are already visible and should pave the way for more robust growth in 2016.”

Danske expects Estonia to bounce back from sluggish 1.8% GDP growth in 2015 to 2.7% in 2016, with Latvia climbing from 2.5% to 3% and Lithuania moving from 1.7% to 2.8%. Inflation will remain well under 2% in all three.


Domestically, it will be interesting to see how the unlikely coalition between the pro-business, market-liberal Reform Party (and a rightist partner) and Social Democrats will fare in its first full year after the election. The parties agree on a couple of social progressive issues that dominated the news in 2015 (same-sex partnership, refugee quotas), but there remain significant ideological divides particularly on such issues as tax policy. If a split does happen – and If the EU's refugee experiment goes horribly wrong – the far-right Conservatives could pick up momentum and become power-brokers. But this does not seem likely.

Only one election is on the calendar: who will replace the influential Toomas Hendrik Ilves (himself a former Social Democrat elected by a Reform Party-led parliament) as president. The leading popular pick at this early stage is the foreign minister, Marina Kaljurand, who has some ethnic Russian roots yet is expected to be quite tough in dealings with the Russian Federation. She also has the benefit of a more down-to-earth image than the overtly intellectual Ilves.

Speaking of Russians, a veteran politician beloved by Russian-speakers, Edgar Savisaar, has proven yet again he is a great survivor both physically (after having a leg amputated) and politically after batting away yet another corruption scandal. But as soon as he does finally exit the scene, the question will be who fills the void. Aware of the danger of having a quarter of the population with no political leadership except from Moscow, Estonian Public Broadcasting's Russian-language channel went live this year as a counterweight to powerful Russian Federation TV, so it will be interesting to see whether it can pick up viewers or be just a token gesture.

Estonia is in fact not as tough on Russia as its rhetoric would suggest. For example, officials will often in the same interview assail Russia for annexing Crimea and yet press for a border treaty that arguably legitimises a Crimea-style grab of Estonian territory (albeit from a long time ago). The return of Estonian security agency Eston Kohver via a spy trade at the border shows willingness for realpolitik behind the rhetoric.


After a few brief years as the poster child of austerity and after completing a fairly successful presidency of the EU in the first half of 2015, Latvia enters 2016 completely rudderless. Following the resignation of prime minister Laimdota Straujuma on December 7, at the time of writing a staggeringly apathetic search for a replacement continues.

The favourite for the job – if such a word does not suggest too much enthusiasm – is former European commissioner Andris Piebalgs, with veteran political fixer Maris Kucinskis and Unity party leader Solvita Aboltina outside bets. Piebalgs is the only one with any chance of lasting more than a year.

More interesting by far are indications that Latvia is finally getting serious about tackling the massive money-laundering operations of its boutique banks. The recent decision to hand out a record €2mn fine to PrivatBank was a clear signal that severe pressure is being brought to bear, not least from the US which is perhaps understandably suggesting that if its troops and tax dollars are defending Latvia from Russia, it's rather rude of the locals to launder billions of other dollars for Kremlin flunkeys.

The inaction in recent years of the financial regulator, the Financial and Capital Markets Commission (FKTK), and its denial that there was even a problem makes it likely that FKTK chairman Kristaps Zakulis will get the chop at some point this year as a sacrificial offering in order to try and keep yearned-for OECD membership on track. However, we think it will be too little too late and Latvia will suffer the embarrassment of being asked to wait another year so it can join with Lithuania.

Meanwhile, expect more fines on banks and perhaps even a licence or two to be taken away.


On the whole things seem to be ticking over quite nicely in Lithuania – which essentially will be the election pitch of incumbent Prime Minister Algirdas Butkevicius in the autumn when the country holds parliamentary elections.

While Butkevicius has not been spectacularly good, nor has he been spectacularly bad. But history suggests Lithuanians like a bit of excitement whenever possible (they are not called the Italians of the Baltic for nothing) and that could come in the shape of Gabrielius Landsbergis, grandson of independence-era icon Vytautas Landsbergis and now chairman of the Conservative Party.

The youthful Landsbergis could manage something along the lines of Justin Trudeau's coup in Canada – particularly if something goes wrong with the economy (unlikely), or the Social Democrats in power are seen as being too soft on immigration. Despite their own propensity to emigrate to Western Europe in massive numbers and the relatively small number of asylum seekers allocated to them under the EU’s redistribution plan, Lithuanians (and Estonians and Latvians) are providing perhaps the least enthusiastic welcome to refugees of all, for once revelling in their miserable climate's potential to keep people from warm climes away.