EU predicts Eurozone weakness will crimp Central Europe's growth

By bne IntelliNews November 4, 2014

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The European Commission on November 4 cut its forecast for Eurozone growth to  1.1% next year, down from a forecast of 1.7% just six months ago. The forecast for growth of German gross domestic product was almost halved to 1.1% from 2%, a serious threat to the countries of Central Europe, for whom it is their biggest export market. 

Nevertheless the Commission expects growth in Central Europe to remain reasonably robust, though still far below the levels before the global financial crisis, or those needed to converge rapidly with Western Europe.

Czechs back in demand

The Czech Republic  suffered from falling domestic demand throughout the global financial crisis and the Eurozone crisis, which has put an undue dependence on exports as the only meaningful driver of economic growth. However, that is changing, suggests the EU, thanks to the end of the previous government's much criticized harsh austerity. 

An improving labour market and lowered tax burdens are helping boost private consumption, and will continue to do so to the end of 2016, the report predicts. Investment - both public and private - is also increasing. Overall, gross fixed capital formation is expected to grow by 4.3% in 2014 and moderate somewhat over the forecast horizon, with EU-backed public investment falling off in 2016.

"Domestic demand has rebounded strongly in recent quarters and is expected to be the key driver of growth over the forecast horizon," the report says. "Overall, real GDP is forecast to grow by 2.5% in 2014 and to strengthen slightly to 2.7% in both 2015 and 2016."

Not that exports will make no contribution to growth, given that they account for a whopping 77% of GDP in the small and open economy. While the EU admits risks remain because of the slowdown in the Eurozone - the Czech Republic has minimal trade exposure to Russia and Ukraine - the Czech National Bank's weakening of the crown continues to support exports.

Hungary running out of steam?

To the south, Hungary has been outgunning most forecasts this year as growth shoots higher. Indeed, the EU has raised its 2014 outlook to 3.2% from the 2.3% it expected in the spring. However, many warn that the recovery is overwhelmingly state-led, and worry that mid-term prospects look tougher because of the effects of erratic government policy on investment and credit.

Not surprisingly, the EU is in that camp, suggesting growth is set to moderate as the effects of one-off factors - such as accelerated absorption of EU funds and the central bank's Funding for Growth Scheme of subsidised loans to SMEs -  fades. While GDP should reach around 3.2% this year, it forecasts growth will slow to 2.5% in 2015 and 2% in 2016.

In particular, it warns the 16.8% rise in investment seen in 2014 won't last, meaning private consumption will have to take over as the main driver; albeit Budapest's enforced scheme to make banks offer relief to mortgage holders will help. Exports are set to drop slightly because of the problems in the Eurozone. 

"Moreover, Hungary could be severely affected if the Russia- Ukraine crisis deepens, through both the real economy and financial channels," the reports suggests. It also cautions that any tightening of global monetary conditions is a risk, given the high volume of foreign currency debt in the country.

That would put strain on the currency and therefore Hungary's fiscal policy, with the state holding a large debt burden. In turn, the government could  struggle to keep the deficit under control. For the meantime, however, the deficit is projected to fall from nearly 3% of GDP this year to 2.5% in 2016.

At the same time, inflation is likely to recover as imported inflation rises and the base effect of regulated energy price cuts wears off. Inflation is expected to reach 2.5% in 2015 and, as the output gap closes, 3% in 2016.

Double Polish whammy

Unlike its peers in the region, Poland's spring forecast of 3.2% was revised downwards by 0.2 percentage points in the latest EU outlook, as "tensions beyond Poland's eastern borders and, more importantly, weak external demand, especially in the Eurozone hit exports and private investment". However, overall domestic demand should still act as a counter-weight, the European Commission suggests, to leave GDP growth in 2014 at 3%; a significant boost from last year's 1.7%. 

Yet the slowdown in the Eurozone and the problems in Russia and Ukraine - to which Polish trade is far more exposed than other Central European countries - will drag 2015 economic expansion back down to 2.8%, the report suggests; a poor effort compared to the 3.4% expansion predicted in May. Those predictions are below government expectations of over 3.3% in 2014, followed by 3.4%. 

However, the slowdown in exports growth and investment is expected to be only temporary, as the negative impact on the Polish economy from the Ukraine conflict is assumed to peter out in 2015. That should help a broader recovery of external demand accelerate Polish growth to 3.3% by 2016.

Private consumption - the cornerstone of Poland's relative resilience to external crisis in recent years - is set to remain strong on the back of growing real wages and further improvements in the labour market. The EU expects unemployment to decline to 9.5% this year, 9.3% next year and to 8.8% in 2016. This improvement is set to sustain nominal wage growth and, in turn, an increase in real disposable income. On top of that, public investment is likely to gather pace next year as new projects financed by the EU are rolled out. 

Against this background, the report expects inflation to ease to 0.2% in 2014 from 0.8% in 2013, driven by very low external inflationary pressure coupled with the effect of a good domestic harvest on food prices. It should rebound to 1.1% in 2015, on the back of the assumed recovery in energy prices and positive base effect of food prices, and further to 1.9% in 2016, fuelled by higher import prices and a sustained improvement in domestic demand. 

Slovaks back on the job

Like the Czech Republic, Slovakia's domestic demand has been dire for some time, but will now need to come to the fore to make up for lowered export demand because of the Eurozone slowdown. Reflecting the similarity, the EU raises its spring forecast for GDP growth by 0.2pp to leave it at 2.4% for 2014. 

"After three consecutive years of decline, private consumption, which rebounded strongly in the first two quarters of 2014 thanks to growing real disposable income and an amelioration of consumer confidence, is expected to increase by 2.8% over the year as a whole," the report states. Private investment is also set to continue the growth seen in 2014, with equipment and construction a major element.

Those increases come on the back of improvements in the labour market, which have been in a slump for some years. "While unemployment in Slovakia remains at elevated levels, the first half of 2014 saw a steady fall in the unemployment rate," the European Commission says. "Over the forecast horizon, labour market conditions are expected to improve gradually as the economy recovers. The unemployment rate is projected to be 13.4% in 2014 and to then fall to 12.8% in 2015 and to 12.1% in 2016." 

However, the prediction for next year has been substantially lowered by 0.6pp to 2.5%, with exports to continue to struggle after they dropped sharply in the second quarter of 2014, mainly because of slow GDP growth in Slovakia's main trading partners. A rise to 3.3% is on the cards for 2016, the EU suggests.

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