COMMENT: CEE fiscal short-termism threatens infrastructure investment

COMMENT: CEE fiscal short-termism threatens infrastructure investment
The problem may be compounded, if the next multi-year EU budget for 2021-27 period brings a reduction in funding for infrastructure.
By Otilia Dhand of Teneo Intelligence March 8, 2018

While all governments of Central and Eastern Europe (CEE) declare a goal of improving infrastructure, levels of investment have actually been declining over the past decade. Political populism has led to short-termism in fiscal policy, as current government expenditure on public sector wages and social support programmes is increasing at the expense of long-term investment. Lack of investment has slowed down the convergence in infrastructure quality towards the EU average and may constrain medium-term economic growth. This prospect is aggravated by the emerging debate on possible linking of future EU cohesion funding to EU values, the very topic of the clash between Brussels and more than one CEE capital in the past two years.

A report of the European Investment Bank (EIB) from November last year observed that even as European economies started to grow after the crisis years, infrastructure investment has levelled off at 80% of pre-crisis investment rates. The most significant drop was in the transport sector, where, crucially, CEE countries have a lot to catch up with to converge to the EU average. In fact, the countries that have the lowest levels of infrastructure quality appear to be the most affected by the fall in infrastructure investments and their convergence process has slowed down significantly.

The EIB report documented that the key driver of the decrease in infrastructure spending has been the withdrawal of governments from infrastructure activities, as they seek to achieve balanced budgets and, at the same time, shift public spending away from gross capital formation towards current expenditure. While cyclical factors partially explain this shift, political preferences driven by short-term consideration appear to be a major factor behind it.

The chart above reflects the aftermath of economic crisis and austerity in 2011-12 when governments cut spending to meet convergence criteria towards a long-term goal of balanced budgets as required under the 2012 European Fiscal Compact. While the investment appeared to be rebounding in 2014-15, this spike in gross capital formation was caused by the governments’ race to meet the 31 December 2015 deadline to draw the last remaining funding from the European Union’s 2007-2013 budget period.

A sharp drop, well below the levels recorded in the austerity period, followed in 2016 and dispelled the myth of rebounding government investment. The key driver behind this drop is the combination of growing short-termism in political decision-making and the constraint of convergence towards balance budgets required under the fiscal compact.

Populist short-termism

Populist parties, which claim to champion the interests of common people against the corrupt political and business elites, have come to power in Poland and Hungary in recent years. Given the positioning of populist leaders as the champions of the poor and those left behind by the transition to the globalised market economy in the past two decades, these parties tend to prioritise social spending over investment.

At the same time, the balanced budget requirement and automatic brakes on government spending when debt hits specified levels, create added constraints. Again, short-term political cycle incentives trump long-term economic development considerations and governments across the region have tapped long-term resources to address immediate budget gaps. An example of this is the recent targeting of the second pillar of pension systems in all four Visegrad Group countries to help redress the budget deficit or public debt issues.

Similarly, increased social spending or public wage hikes are being offset by cutting funding for long-term investment, for example in transport or digital infrastructure. In Poland, the government’s capital spending dropped from 4.4% of GDP in 2015 to 3.4% a year later as the ruling Law and Justice party (PiS) cut the pension age and increased social support for families. In Romania, the government shifted resources earmarked for investment in transport infrastructure to plug the hole in current spending, which had been caused, for example, by increased public sector wages in August last year.

Short-termism in fiscal policy will likely persist in the coming years, because public support for populist governments is underpinned by increasing social spending, which comes at the cost of long-term public investment. This suggests that the slowdown in the convergence of CEE infrastructure quality to average EU standards will continue and likely constrain economic growth outlook for the region in the medium term.

The problem may be compounded, if the next multi-year EU budget for 2021-27 period brings a reduction in funding available to these countries. Future cohesion funding may be linked to the rule of law and EU values. This may negatively impact Poland, Hungary and Romania, which have recently both recorded a drop in government investment levels and clashed with the EU over the rule of law.

Questionable alternatives

Several governments have turned to public-private partnerships to top up infrastructure investment spending, but the overall picture has not improved significantly. Others look to China. However, Chinese infrastructure funding typically comes in the form of loans, rather than investment, and with clauses obliging the participation of Chinese construction companies in the project. While such projects are booming in the Balkans, for CEE countries they will likely clash with EU competition regulation. One example is the Chinese-funded project for the Belgrade-Budapest railway, which had to be delayed and its procurement processes redesigned to bring it into line with EU regulation. The necessity to comply with EU competition law will likely constrain Chinese interest in CEE infrastructure projects, though CEE governments will likely continue to bid for it.

Yet another alternative, admittedly available only to the larger countries in the region, is to boost long-term domestic resources. Polish Prime Minister Mateusz Morawiecki’s trade-mark economic development plan counts on an expansion of long-term savings. In February this year, the Polish government announced a planned revamp of the pension system aiming towards this very goal. A week later, Morawiecki presented a vision of the Polish economy driven by so-called national champions, or large state-controlled companies that play a key role in their respective industries, especially finance, energy and commodities. However, it remains to be seen whether this radical overhaul vision leads to success, rather than scare away foreign investment that has driven Poland’s economic growth over the past two-and-a-half decades.

Otilia Dhand is Senior Vice President at strategic consultancy Teneo Intelligence, specialising in Central and Eastern Europe.