VIENNEAST COMPASS: Risk outlook 2020 – balancing in limbo

VIENNEAST COMPASS: Risk outlook 2020 – balancing in limbo
CEESE had a good year in 2019, with the economies in the region buoyed by increasing domestic consumption and capital spending that allowed the region to decouple from western Europe.
By Marcus How of Vienneast in Vienna January 14, 2020

The cake was abundant, and everyone ate a slice: despite a mounting global economic slowdown and regional geopolitical instability, CESEE had a good year, all things considered.

Economies in the region held up well, buoyed by increasing domestic consumption and capital spending. Where the German and Italian economies flatlined, the European Commission estimates that gross domestic product (GDP) in the 21 countries of CESEE will have grown in 2019 by approximately 3.1% on average. Within the EU-CEE states, it is likely to amount to 3.3%. Illiberal authoritarianism was no impediment: annual growth rates in Hungary and Poland are estimated to be 4.6% and 4.3% respectively, while Serbia is likely to have had another record year in terms of foreign direct investment (FDI).

Politically, it was lively but with few shocks. Liberal opposition forces posted some wins: in local elections in Hungary and Turkey and in presidential elections in Slovakia, Croatia and Romania; however, incumbent nationalists remained entrenched in strategic centres throughout the region, not least Poland, where the Law and Justice Party (PiS) romped home with a historic share of the vote in the parliamentary election.

More generally, 2019 proved the heterogeneity of CESEE, with its contradictory outcomes and resistance to easy categorisation. In Poland, PiS reaped the rewards of its heady mix of clerical conservativism and left wing-flavoured economics, especially among the young. In Ukraine, Volodymyr Zelensky and his self-moulded party, Servant of the People, won a landslide on a muddled populist platform caught somewhere between Macronian centrism, pragmatic nationalism and oligarchic masquerade. In Moldova, President Ihor Dodon’s pro-Russian Socialist Party (PSRM) propped up a government formed by the pro-European NOW Platform to oust the oligarchic hegemon of the Democratic Party (DPM)’s Vlad Plahotnuic – only to ally with the latter to dramatically purge the former once its purpose had been served. The Union State between Belarus and Russia was deepened – but amid growing unhappiness in Minsk.

Neither was the Western Balkans spared the geopolitical theatre, leaving the south-eastern flank of the EU in characteristic limbo. Emmanuel Macron vetoed the launch of EU membership negotiations with North Macedonia and Albania, leaving confused disaffection and irritation in his wake. Serbia played all sides, signing a free trade agreement (FTA) with the Eurasian Economic Union (EAEU) that will automatically become null and void if it accedes to the EU in 2025, while proposing a ‘mini-Schengen’ zone in the Western Balkans that would paradoxically exclude Kosovo and Bosnia-Herzegovina.

The perils of foresight

We expect that 2020 will be a year in which the dust settles in CESEE. Global or regional black swans aside, the risk outlook will not change but the trends underlying it will become clearer. These include:

1. Wind in the sails

Global macroeconomic conditions will continue to deteriorate, with slowing exports biting in the EU-CEE and Western Balkans in particular, but the region will maintain its rhythm owing to its emergence as a relative safe haven. If 2019 demonstrated anything, it is that although the Central European supply chain may be integral to the respective national economies comprising these subregions, they are no mere outsourcing centres, and although the long march to development has been slow, its trajectory is upward. Robust macroeconomic stewardship has complemented increasing domestic demand, even if structural reform has lagged in most countries, been half-baked and haphazard in many cases, with the spectre of long-term factors such as demographic decline, institutional inefficiency and middle-income traps looming large.

Nonetheless, in the event of an external macroeconomic shock, CESEE economies are in a far better position than a decade ago in 2009, when currency volatility and overleveraged banks created a downward cascade that swamped borrowers.

2. Sustained decoupling

The robust economic performance of CESEE, especially Central Europe, indicates that the region has decoupled somewhat from Western Europe in a way that would not have been possible a decade ago, with growth momentum being sustained in its own right. At the very least, this will provide a cushion against potential external shocks. Yet it is also indicative of the potential for psychological drift, a parallel symptom of which has been the changing of mentalities with respect to political economy, with its corresponding impact on institutional quality. Political culture aside, this is likely to impact a wide range of risk categories, not least corruption, regulatory, contract and legal.

Ursula Von der Leyen’s newly formed European Commission is unlikely to take decisive action to address this divergence or drift in 2020. The thin majority of her administration in the European Parliament, combined with the lack of the requisite unanimity among EU member states to trigger Article 7 proceedings against Poland or Hungary, will prevent radical action. However, the groundwork for longer-term action will likely be laid, such as through the tying of EU structural funds to the rule of law.

3. Strategic limbo – there are worse places to be

Furthermore, CESEE is likely to gain relative strategic autonomy in an increasingly multilateral global environment in which small- to mid-sized economies must position themselves pragmatically. Although the EU remains of structural importance to CESEE, 2019 provided a rude awakening. Enlargement became a tentative prospect; geopolitical limbo looms, a reality which North Macedonia and Albania bore the brunt of in 2019.

The French veto was not the end of enlargement. It is likely that progress towards pre-accession negotiations will be made at the EU-Western Balkans Summit in May. However, the veto demonstrated that, at best, geopolitical paths are not dependent but contingent, zigzagging according to capricious wills both at home and abroad. The greater the uncertainty, the wider the potential breadth of the zigzag. The veto thus had a symbolic impact for aspirant EU member states whose reform efforts have largely amounted to box-ticking.

Yet there is a competitive advantage to be enjoyed in limbo. Western Balkan states in particular enjoy relatively frictionless access to EU markets, thereby attracting not only FDI from the EU, but also from China, Russia and Turkey. The Serbia-EAEU FTA is a case in point: foreign companies are not investing in Serbia in spite of contradictory geopolitical arrangement like the FTA, but often because of them. Serbia is using the geopolitical limbo in which it finds itself to enhance its unique gateway position. It is likely that other countries in the Western Balkans will proceed along a similar path, which is also observable in Belarus and Moldova. Meanwhile, local elites whose hegemony relies on maintaining this balancing act will find themselves strengthened.

4. Liberal renaissance splutters

The last year demonstrated that liberal forces are, at the least, alive and in some cases well in a region that is commonly associated with nationalist authoritarianism. Hungary, Slovakia and especially Romania were noteworthy examples of this. However, liberal political parties remain fragmented and lacking in strategic vision.

The Slovak parliamentary election in February is likely to produce a chaotic political landscape, with North Macedonia following suit in April. In Romania, the National Liberal Party (PNL)’s minority government must contend with a deteriorating fiscal situation inherited from its predecessor ahead of parliamentary elections in December. In Poland, Civic Platform’s presidential candidate, Malgorzata Kidawa-Blonska, could unseat the PiS incumbent, Andrzej Duda, in May, but this is far from certain.

Meanwhile, Western Balkan strongmen Aleksandar Vucic and Milos Dukanovic are highly likely to safeguard their respective fiefdoms in Serbia and Montenegro, in April and October. Regional politics will remain characteristically heterogeneous in 2020.

5. Institutional individualism

Throughout much of CESEE, the absence of strong institutions enhances the role of individuals. Patronage networks conducive to nepotism, cronyism and corruption are symptomatic. Little has changed in this respect over the past decade, with institutional development stagnating. In countries such as Hungary, Turkey, Poland and Serbia, institutional development has even weakened, although there have been tentative improvements in Romania, Latvia, North Macedonia and Slovakia. Overall though, according to the World Bank’s World Governance Indicators (‘WGIs’), the average score of CESEE in the key categories of ‘rule of law’ and ‘control of corruption’ has stagnated, with the former rising slightly from 56.1 in 2010 to 56.9 in 2018, and the latter declining from 53.6 to 53.4.

Like many benchmarks, the WGIs are insufficiently qualitative, registering improvements such as legislative reform but overlooking the extent to which new rules may not always be applied fairly or consistently. Yet poor institutional quality is not necessarily an impediment to investment. The centralisation of informal power in countries such as Hungary and Serbia, which lead CESEE with respect to FDI, can also provide opportunities. If foreign investors plan ahead, mapping out the risk landscape, identifying which sectors to avoid and advocates to approach, they can enjoy bespoke treatment for their projects. Obstacles such as local corruption and slow permitting can also be cleared this way. The key is how to leverage political patronage without overstepping ethical or legal boundaries, with smart investment careening into foreign corrupt practices.

6. Russia – from the doghouse to the kitchen doorway but not beyond

Finally, relations between the EU and Russia are likely to show some signs of thaw in 2020. The trigger will be the likely agreement between Ukraine and Russia to a lasting ceasefire in Donbass. This will be an incremental step; Moscow will make no territorial concessions, leaving Donbass in a state of limbo as per Transnistria, Abkhazia or Northern Cyprus. Yet it will be sufficient to justify the gradual unpicking of the EU sanctions regime, which is tied specifically to Russia’s conduct in Ukraine (in contrast to the scattershot and wider approach of the US regime). Little more will be done, given the lack of unanimity among EU member states with respect to policy towards Russia.

The tentative rapprochement will signal further geopolitical drift between the EU and US, already apparent on Iran and the Middle East. On the issue of Russia, this will likely continue regardless of whether Donald Trump wins a second term in the US presidential election. A key objective of US foreign policy is to assert its energy interests in Europe through the sale of liquified natural gas (LNG) and the shrinking of Russia’s market dominance. As such, it will expand its sanctions regime to target Russian projects, such as Nord Stream 2, including by displaying a willingness to punish EU companies, as it did Switzerland’s AllSeas in 2019. In practice, this is not likely to amount to much more than political noise, although it will increase legal uncertainties and overall risk for EU energy companies.

Safe harbour amid a gathering storm?

With the exception of Russia and Turkey, CESEE is likely to continue to offer comparative predictability for investors in 2020. The primary risks originate from outside the region, with the action occurring elsewhere. Macroeconomic indicators will slow but remain robust, cushioning somewhat against such shocks. Institutional mediocrity, if not outright weakness, will prevent the effective resolution of longer-term structural issues, but the flexibility and informality of such systems, combined with the gateway status of numerous countries in the region, will continue to accommodate strategically-minded foreign investors on an ad hoc basis. Frontier states in the Western Balkans and the former Soviet orbit will leverage the benefits that a precarious geopolitical balancing act affords. Any steps in tentative rapprochement between the EU and Russia will be incremental. Political risks in most states will remain subdued; no major shifts are likely, even if liberal political forces make gains in individual states.

 

Marcus How is the Head of Research & Analysis at ViennEast Consulting GmbH

 

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