Emerging Europe – Growth gradually slowing

by: Nora Neuteboom

  • Growth spurt in Emerging Europe (3.8% in 2017) will gradually cool over the coming two years (3.1% in 2018 and 2.6% in 2019)
  • Tight labour markets set the stage for higher inflation in 2018
  • Monetary conditions will remain accommodative across the board
  • The ‘turn towards illiberalism’ and geopolitical risks, pose a serious threat to the growth outlook
180129-Emerging-Europe-2018.pdf ()

Growth in Central and Eastern Europe, Russia and Turkey surprised to the upside

In 2017, the surge in growth to 3.8% yoy (regional GDP-weighted growth index) in Emerging Europe[1] was led by strong activity in Turkey (6.5% yoy) and Romania (6% yoy), while the three biggest Central and Eastern Europe (CEE) economies (Poland, Hungary, Czech Republic) reported GDP growth figures around 4% yoy. Looking at the CEE region[2] in isolation, we saw a regional growth figure of 4.7% in 2017. Russia grew by a moderate 2% yoy, however this can be interpreted as a positive surprise as well, given that Russia was still facing a recession in 2016. Ukraine continued its recovery, with 2% growth in 2017, after a deep recession in 2014-15.

In the CEE region, private consumption was the main growth driver, underpinned by rising real wages and household incomes. However, investments and exports also staged a recovery in 2017. Strong inflows of EU funds and low interest rates caused investments to rebound. The recovery in exports was led by the uptick in the eurozone, as the region finally showed GDP figures above 2% after a long period of subdued growth (see: Eurzone Outlook: Capital spending leads the way  ). In Russia, the recovery is supported by gains in the crude oil price (Brent oil price increased 18% over the course of 2017) and the stabilization of the ruble (see: Russia Watch: Discipline will help growth). In Turkey, the acceleration of growth, amidst political instability, was driven by the beneficial effects of the government’s stimulus package (see Turkey Watch: On the eve of change).

CEE region faces gradual slowdown after growth peak in 2017

Looking at the CEE region, we think growth will decrease from a high of 4.7% in 2017 to 3.9% in 2018 and 2.2% in 2019. This is based on the following assumptions:

  • The global picture will continue to be benign in 2018. We expect global growth to remain around the same level in 2018 (3.8%), with growth in the eurozone picking up (from 2.3% in 2017 to 2.8% in 2018).
  • Despite continued strong demand from the eurozone, we anticipate that net exports will negatively impact GDP growth in 2018. The appreciation of local currencies will weigh on exports, while imports will continue to be supported by the strength of domestic demand.
  • Despite growing inflationary pressures, we only foresee a gradual tightening of monetary policy in the CEE region. The monetary policy of both the ECB and the FED will remain accommodative throughout 2018, so we will not see a sharp deterioration in financial conditions.
  • Due to the political tensions between some CEE countries (Poland, Hungary and, to a lesser extent, Romania), we don’t expect foreign investments to surge in 2018. That said, EU funds, which were already approved 2014, will continue to flow to the CEE region.

For Russia and Turkey, the growth outlook is linked to the political situation

As concerns Russia, we expect public investment to increase ahead of the presidential elections in March 2018. Meanwhile, the Russian economy will also benefit from higher oil prices (we forecast Brent at USD75/bbl end-2018, see Commodity Update: Good start of the year for commodities). However, low productivity, a shrinking workforce, a relatively strong ruble and international sanctions weigh on the outlook. Overall, we expect growth in 2018 to be around the same level as 2017, at 2%. In 2019 we anticipate growth returning to trend growth (1.5%).

For Turkey, the stimulus from the substantial government package, implemented right after the failed coup, will wear off (it was estimated that this added around 1.5% to the 2017 growth figure). Still, it is very uncertain at this point which (fiscal and monetary) stimuli will continue and which will be removed. If there is a political need to carry on stimulating the economy, new pro-cyclical policy may be implemented. High inflation (which is partly import inflation) will weigh on consumption. Also, the deteriorating current account deficit, volatile currency (lira) and the gradually tightening by the Fed will daunt foreign investment. All in all, we believe that growth will fall to 4.5% in 2018 and 4% in 2019. While this is lower than 2017 (6.5%), it is on trend (the 20-yr average growth in Turkey is 4.5%). That said, these forecasts may prove too bearish if the government decides on new stimuli going forward.

Substantial improvements in the labour market

With few exceptions, the number of employed in most CEE countries now exceeds the pre-crisis level. Rising employment levels are mirrored by declining unemployment. Apart from higher economic growth, demographic factors such as a shrinking labour force, an ageing society and constant outward migration are key factors behind the falling jobless rates. Nonetheless, the situation differs between countries. Whereas the Czech Republic is currently at full employment (unemployment rate is 3.5%), unemployment in Bulgaria is still high (around 12%). Many vacancies in CEE countries, such as in Poland, Hungary and Czech Republic, are currently being filled by ‘migrant’ workers from Ukraine and the Balkan countries. While unemployment rates improved in the CEE region, Russia and Turkey are lagging behind. In Russia, unemployment rates have not improved and have hovered around 5% for a few years now. In Turkey, jobless rates have actually gone up due to labour market rigidities, from around 8% in 2011-12 to around 12% in the beginning of 2017.

Higher wages feed into higher inflation

Against the background of solid growth, unemployment rates at historically low levels and higher energy prices, inflationary pressures are building in the region (with the exception of Russia). In 2017, our regional (GDP-weighted without Russia) inflation rate was 3.7% yoy on average. This was 2.4% in 2017.

Inflation is particularly high in Turkey and Ukraine (above 11% and 14.5% respectively), but this is mainly due to other factors, such as currency depreciation (import inflation) and fiscal stimuli. Looking at the CEE region, inflation was around 2%, a welcome development after years of deflation. Continuing growth and tight labour markets set the stage for further inflationary pressures in 2018. While the CEE region was fighting deflation, Russia won its battle against inflation in 2017. CPI fell from 7% yoy on average in 2016 to a level of 4% yoy on average in 2017 (on target of the Russian Central Bank). Inflation subsided as the impact of past currency depreciations wore off. Furthermore, strong harvests and relatively tight monetary policy helped bring down inflation.

Higher inflation, however, does not set the stage for higher rates in CEE and Turkey

In 2017, monetary conditions continued to be very accommodative the CEE region and Turkey. Higher inflation and robust growth prompted the Romanian central bank to narrow the interest rate corridor in October. At its November meeting, the Czech National Bank increased its two-week repo rate from 0.25% to 0.50%. Czech Republic will likely continue their tightening as inflationary pressures are building. Meanwhile, policymakers in Hungary and Poland left key interest rates unchanged despite increasing inflation rates. For 2018, taking into account growth and inflation dynamics as well as a slow normalisation by the ECB, we expect the regional monetary policy stance to turn more hawkish, albeit very gradually. The Hungarian central bank seems to be acting as a vanguard as it maintains its easing bias despite that inflation is above the 2.5% target and an overheating labour market. The Polish central bank has promised to keep interest rates unchanged for another year. We do not foresee (gradual) tightening before the start of 2019, but expectations and signals from the central bank will likely already come in the second half of 2018.

In Turkey, inflation trended upwards over the course of 2017, remaining considerably above the Central Bank’s target. The Turkish Central Bank (CBRT) increased its one-week interbank rate and the average cost of funding went up from around 9% initially, to a current level of 12.75% (Jan-18). Yet, real interest rates are still negative. Our baseline scenario assumes a gradual increase in the average interest rate in 2018, as inflation pressures will not ease substantially. Even so, the CBRT rate policy is very much influenced by the current government (AK Party of Erdogan), which favours low rates to stimulate credit flow (and hence economic activity). Therefore, both the scenario lower rates for longer, as well as, a sudden significant hike are realistic in 2018. For a more detailed view on the CBRT’s monetary policy, see our latest Turkey Watch: On the eve of change.

Inflation in Russia fell substantially in 2017 and the Central Bank of Russia (CBR) has continued its easing trajectory. The policy rate was lowered by a total of 225bp, from 10% to 7.75%. Given our moderate inflation expectations (4.5% at end-2018), we expect the CBR to further relax its monetary policy next year. We forecast a total cut of 100bp, to 6.75%, by end-2018, just above the nominal equilibrium rate of 6.5% (calculated by the CBR).

CEE recovery taking place against a background of inconsistent policy mix

Hungary, Romania and Turkey are pursuing a pro-cyclical fiscal policy despite brisk economic growth and low unemployment rates. Meanwhile, the European Commission’s Excessive Debt Procedure is looming for Poland and Hungary. As both countries exited the EDP procedure only a few years ago, their budget deficits are close to the Maastricht criteria of 3% (2.7% for Hungary in 2017, 1.7% for Poland in 2017 but according to the EIU this may increase to above 3% in 2018 for Poland). We assume that the governments want to avoid being subject to the EU’s Excessive deficit procedures again, and will take appropriate measures to limit the deficits to below 3%. Czech Republic is an exception to the rule, reporting a positive budget balance (1.3% of GDP).

Both Turkey and Russia have relatively low government debts. Ukraine, on the other hand, has one of highest government debt levels in the Emerging Europe region (almost 90% of GDP). What mitigates the risks is that in March 2015, the IMF approved a four-year Extended Fund Facility for Ukraine (USD 17.5bn), which also includes a plan to improve the government’s financial conditions. That said, so far only Ukraine has only received USD 8.5bn, as the IMF is not satisfied with the progress made.

Government debt is relatively high in the CEE region, especially in Hungary (74% of GDP). However, we project that the government debt-to-GDP ratio will go down over the coming two years. Rising inflation is positive for the total debt pile, as is continuing economic growth.

Main risks to the outlook

While our base scenario foresees economic growth in Emerging Europe remaining solid in 2018 and 2019, there are several risks that could threaten the outlook:

  • Faster-than-expected tightening by ECB or FED. A faster-than-expected rate hike cycle (by either the FED of the ECB) may lead to currency and interest rate shocks in Emerging Europe. This is especially true for Turkey, which has the most vulnerable external position in the region.
  • Flare-up of conflict in Eastern Ukraine. There is a risk that the conflict will further escalate if a (military) incident occurs in the Donbass region. This would cause the already fragile peace talks to fall apart.
  • Illiberalism and (geo)political tensions with the EUThe resurgence of authoritarianism and illiberalism in Emerging Europe, specifically in Russia and Turkey but also in Poland and Hungary, could threaten investor confidence in the region.
  • A more stringent interpretation of the current sanctions and/or additional sanctions against Russia. A strict interpretation of the new sanctions regime (CAATSA) could lead to personal sanctions on individuals in Putin’s inner circle, causing a further deterioration of the already weak relations between the US and Russia. Furthermore, if the investigation into the alleged meddling of Russia in the US Presidential elections reveals concrete links between the Kremlin and the Trump administration, new sanctions by the US may be invoked.


[1] The Emerging Europe region includes: Belarus, Bulgaria, Croatia, Czech Republic, Hungary, Poland, Romania, Russia, Slovakia, Slovenia, Turkey and Ukraine.

[2] The CEE region includes: Bulgaria, Croatia, Czech Republic, Hungary, Poland, Romania, Slovakia and Slovenia.