In our previous publication, Emerging Europe Watch: growth gradually slowing, we mentioned that while growth prospects are strong for the region, several risks remain. In this publication, we dig deeper into the risks to see what impact they could have on our base case scenario.180219-Main-risk-in-Emerging-Europe.pdf (275 KB)
Base case scenario: economic growth will slow but remain solid
Emerging Europe experienced a growth spurt in 2017 of 3.8% (regional GDP-weighted growth index). The surge was led by Turkey (growth of 6.5% yoy) and Romania (6%), but also the three biggest Central and Eastern Europe (CEE) economies (Poland, Hungary, Czech Republic), which reported GDP growth figures of around 4% yoy. Russia recovered from an economic downturn and reported 2% growth yoy in 2017 while Ukraine continued its recovery with an equal 2% yoy. We expect growth to gradually slow, while remaining above trend (for most countries). For the CEE region we expect growth to slow from 4.7% to 3.9% and in Turkey we foresee considerably lower growth in 2018 (decreasing from 6.5% to 4.5%). Still, this remains around the 20-year average of 4.5%. In Russia, we anticipate that growth will remain at the same level (2%). Below we outline the biggest risks to our growth scenario.
1. Faster-than-expected Fed tightening is a risk for Emerging Europe
External financial conditions for EMs, including Emerging Europe, were benign in 2017. In our base case scenario, we expect the Fed rate hike cycle to remain slow (three hikes in 2018). The ECB is also set for a prolonged period of accommodative monetary policy (see: Eurozone outlook: 2018 capital spending leads the way). We expect no rate hikes in 2018 and two hikes at end-2019. However, a faster-than-expected rate hike cycle (by either the Fed or the ECB) may lead to currency and interest rate shocks in Emerging Europe and increased risk aversion. These risks are especially high in Turkey, which has the most vulnerable external position in the region. The current account deficit as a percentage of GDP is around 5% and is mainly financed by volatile portfolio flows. It is for that reason that Turkey has been included in S&P’s ‘fragile five’ list for many consecutive years. Hungary is also vulnerable to interest rate shocks, as the country has a low import cover of FX reserves (around 2.4 months) and high financing requirements as a percentage of GDP.
2. Growing illiberalism in Eastern Europe
In the past years we have seen a turn towards conservative nationalist values, combined with a lack of civil liberties in Poland and Hungary, and to a lesser extent Bulgaria, Romania and Czech Republic. Within this group, Hungary’s Fidesz party has taken the lead by strengthening its grip on public institutions such as the central bank, the judiciary and the media. In Poland as well, the Law and Justice party (PiS) has been accused of dismantling democracy and limiting civil liberties. So far, investors have largely ignored this emergence of illiberalism and local currencies and bonds have continued to outperform peers. While in our base case scenario we believe that these political risks will continue to have little influence on economic growth, there is a risk that investors will turn their back on Eastern Europe. As growth is about to cool off in the region, investor confidence will be less fuelled by strong economic figures in the near future. This could mean that political events that grab headlines will more easily change investors’ view of the region. A related risk is that personality-driven leadership with weakened institutional controls can be very unpredictable and may lead to inconsistent and poor economic policy.
3. Pushing forward with Article 7 for Poland and Hungary
Related to the previous risk is the decision by the European Commission (EC) to initiate Article 7 sanction proceedings against Poland. The move was in response to judicial reforms that undermined the independence of the judiciary and the separation of powers. At this point, it is unlikely that Poland will face sanctions (i.e. a suspension of its voting rights in the EU) because the EU can only proceed against a member state with unanimity, and Hungary will most certainly veto any move against Poland. The option of last resort for the EU will be to also trigger article 7 against Hungary, thus stripping both Poland and Hungary of their voting rights. This is not part of our base case scenario as we believe the EU would rather opt for a long-term solution in disciplining its members. Like the Stability and Growth pact for the Eurozone, the EU will propose a Democratic Governance Pact, laying down rules for the monitoring and enforcement of democratic values. That said, if Poland and Hungary continue to ignore the EC on issues like democracy, immigrants and the protection of human rights, sanctions cannot be ruled out. And sanctions could open the door for the EC to cut EU funding (which would have quite a significant impact on growth in the region, see: CEE-3 Watch: momentum is here).
4. Unpredictable (foreign) policy by Erdogan poses a risk for Turkey
As economic growth will likely cool in Turkey in 2018, President Erdogan will be less able to use the economic pillar as the basis of his personality cult. He will therefore be more inclined to pinpoint scapegoats (Kurdish minority, Western Europe and the U.S.). In the past, we have seen that financial markets react strongly to (political) issues between Turkey and the West. Examples are the refusal of the U.S. to extradite Fethullah Gulen and the case of the Turkish gold trader who breached U.S. sanctions against Iran. Furthermore, as Turkey is heavily dependent on foreign capital from the West, such events could lead to a loss of investor confidence. The most pertinent risk is related to the ongoing ground offensive by Turkish troops in northwest Syria (Afrin) against Kurdish YPG forces. Erdogan has threatened to move eastwards towards the city of Manbij, where U.S. troops are deployed. In this scenario, the U.S. will be forced to choose between its NATO ally Turkey and its trusted Syrian proxy, the Syrian Democratic Forces (SDF). This substantially increases the likelihood of ‘friendly fire’ and incidents between U.S. and Turkish troops. Furthermore, President Erdogan warned the Syrian government that it risked a military confrontation if it stepped in to help the Kurds in Afrin. We are also seeing a deterioration in the relationship between Turkey and the EU. One example is the withdrawal of the Dutch ambassador to Turkey at the beginning of February, as talks with Turkey reached a stalemate. As the Netherlands is the largest foreign direct investor in Turkey, this deterioration in relations could have an impact on future investment decisions
5. Early elections in Turkey
As approval ratings for the ground offensive are high in Turkey and economic growth prospects for 2018-19 are lower, some analysts argue that Erdogan may push for early elections (which are officially scheduled for November 2019). Following the approval of constitutional changes in the 2017 referendum, incumbent president Erdogan will acquire even more power. This may lead to the re-emergence of mass opposition protests and violent confrontations between Islamists and government opponents, creating instability. Furthermore, western countries will most probably voice their concerns over the backsliding of democratic principles, causing a further deterioration in foreign relations
6. Uncertainty concerning U.S. sanctions against Russia
Last summer, the U.S. Congress passed bipartisan legislation — the Countering America’s Adversaries Through Sanctions Act (CAATSA) — that called for the Treasury Department to submit two reports on 29 January:
- A report on individuals that are well-connected to the Kremlin (the so-called ‘Kremlin list’). These individuals would not face immediate penalties, but the list would essentially serve as a warning shot for Russian elites who could face penalties later.
- A report on the impact of sanctioning Russian sovereign debt on the global financial sector.
The release of the Kremlin list mainly caused confusion as it was seemingly a combination of information from the Russian Forbes and the Kremlin phonebook. According to Anders Aslund, an economist working to compile the list, somebody high up threw out the expert’s work at the last minute and instead included the names of Russian billionaires on the Forbes list. At best, this can be interpreted as a mistake, highlighting the apparent chaos in U.S. sanction policy on Russia. At worst, it can be seen as a move to render CAATSA ineffective as the likelihood of sanctioning the members on the Kremlin list is very unlikely. The sovereign debt report by the U.S. Treasury Department showed that Russia’s sovereign debt market is too important to sanction without risking global financial turmoil. Investors expressed relief following release of the reports and Russia’s international borrowing costs dropped while the ruble gained. The good news for Russia is that the publications did not provide a clear framework for any further sanctions and we therefore believe that the risk of the deepening or widening of sanctions against Russia has eased. That said, uncertainty concerning the U.S. stance on sanctions against Russia remains high. Meanwhile, we must keep in mind that the Mueller investigation into Russia’s meddling in the 2016 presidential elections and possible collusion with the Trump campaign is still ongoing. On 16 February, Mueller released two more indictments, the most prominent one charging 13 Russians citizens and 3 Russian entities in relation to the interference in the 2016 elections. In the indictment there is no evidence of ‘collusion’, i.e. republicans knowingly working together with the Russians. Russian Minister of Foreign Affairs, Sergey Lavrov, dismissed the allegations as not factual. For now it is uncertain how the Mueller investigation will proceed. While it is possible that more indictments will be issued coming weeks, the investigation could also be dragged out beyond November’s midterm elections. Even then, it remains to be seen whether the accusations can be substantiated with solid evidence and, if so, how punishment of the Russian officials involved can be enforced (for more information see also our previous Russia Watch: discipline will help growth).
7. Escalation of Ukraine/Russia conflict
The primary geopolitical risk facing Ukraine and Russia is the ongoing conflict between secessionist groups in the eastern regions of Donetsk and Luhansk and the Ukrainian government. The Minsk II ceasefire from February 2015 has essentially held, although both sides regularly violate it along the line of contact. Given that neither Russia nor Ukraine has a clear interest in escalating the conflict, our base case scenario assumes a frozen conflict. However, escalation is not a risk we can rule out as tensions have built up recently. On 18 January, Ukraine’s parliament passed a law that defined Russia as the ‘aggressor’ and the east of Ukraine as ‘occupied territory’. Russia responded by calling the new law a ‘preparation for war’. So far, this aggressive rhetoric has not resulted in concrete action. However, if a serious incident were to happen along the line of contact, or if the West increases its involvement in the conflict, a military escalation cannot be excluded. Full-fledged military action would take an enormous toll on Ukraine and weigh heavily on its already weak fiscal position. It would also further weaken the position of the government as military action does not have popular support. For Russia, a military conflict may lead to another round of U.S. and EU sanctions. In a worst-case scenario, the EU would impose sanctions on the Russian gas and oil suppliers, hampering investments and economic growth.
 Sum of the short-term liabilities and the current account deficit