Economic Growth Prospects in Central and Eastern Europe

In early 2009, many analysts feared that Central and Eastern Europe (CEE) was hurtling toward a regional crash reminiscent of the East Asian crisis of the late 1990s.

However, by year’s end the CEE region showed cleared signs of having weathered the economic storm. Regional stock and bond markets staged a slow recovery from the losses of 2008-09. Interbank lending rates fell and long-term yields rose in most CEE countries, signaling a stabilisation of the region’s fragile financial systems. CEE exports, which had plummeted in response to falling demand in Western Europe, began a gradual rebound. The contraction of regional GDP had bottomed out, setting the stage for the resumption of economic growth in 2010.

But Central and Eastern Europe’s incipient recovery from the Great Recession will be weak and uneven. At the regional level, CEE growth appears unlikely to reach pre-crisis levels in the foreseeable future, and will fall well below growth rates of other emerging markets. At the country level, the CEE states display wide variations in GDP growth trajectories that demonstrate the region’s increasing diversity.

Links between EU-15 and EU-10

Central and Eastern Europe’s resilience to the turmoil that roiled global financial markets in 2008-09 illustrates the region’s distinctive position among emerging markets. In particular, the pivotal role of the European Union in the CEE countries distinguishes the region from other emerging markets.

In contrast to previous emerging market financial crises (e.g., Mexico 1994, East Asia 1997-98, Russian Federation 1998, Argentina 2001) that triggered extensive capital flight, CEE’s foreign investors did not flee when financial turbulence hit the region. Nordic-based banks, heavily exposed to the "hard landing" of the Baltic states, remained committed to their subsidiaries in Estonia, Latvia, and Lithuania. Similarly, Raiffeisen and other Austrian banks with large investments in Hungary held their positions as that country reeled under the impact of the financial crisis.

The commitment of West European investors to Central and Eastern Europe amid the financial meltdown reflects the tight integration of the EU-15 and EU-10 economies, which well surpasses links between other developed/emerging markets (e.g. Japan and East Asia, US and Mexico). The experience of 2008-09 has prompted the EU’s consideration of accelerating the CEE countries’ adoption of the Euro, a common currency zone that has no counterpart in other emerging markets.

Economic growth trends

But the close interconnectivity of the EU-15 and EU-10 economies also illustrates the degree to which the growth prospects of Central and Eastern Europe hinge on the resurgence of demand in Western Europe, which represents upwards of 80% of CEE exports.

Most of the EU-15 countries are expected to resume GDP growth in 2010. But projected growth rates in the CEE region’s primary export markets (Germany, France, Italy, Netherlands, Sweden, UK) are tepid and dependent on fiscal/monetary stimulus programmes whose effects will soon dissipate. Growth of underlying consumer demand in Western Europe (and hence demand for CEE exports) will remain weak in the coming years as the repercussions of the Great Recession slowly unwind.

Central and Eastern Europe’s growth prospects are therefore guarded. As shown in Exhibit 1, the Great Recession exacted a higher toll on Central and Eastern Europe than other regions. Regional economic output fell by 5% in 2009, surpassing the GDP contraction of the Euro area (4.2%), the United States (2.7%), and Latin America (2.7%). The IMF forecasts a 2010 GDP growth of 1.8% in the CEE region, above the Euro zone and US but below Developing Asia, Latin America, Middle East, and Africa.

Intra-regional patterns

The variations in GDP growth within Central and Eastern Europe reveal much about the economic profiles of the CEE countries.

Exhibit 2 reports the forecasted GDP growth rates of the EU-10 countries in 2010. For comparative purposes, the exhibit also displays the project growth rates of selected emerging markets outside Central and Eastern Europe.

The CEE region breaks down into three groups: (1) Poland, the region’s most robust economy; (2) four countries projected to attain modest GDP growth in 2010 (Czech Republic, Slovenia, Slovak Republic, and Romania); and (3) five countries whose economies are expected to contract in 2010 (Hungary, Bulgaria, Estonia, Lithuania, and Latvia).

Robust growth: Poland

Poland is unambiguously the CEE region’s strongest economy, and indeed the only European country to achieve positive GDP growth in 2009.

Poland’s economic strength reflects the country’s large domestic market (which reduces Polish companies’ dependence on flagging EU export markets), its diversified economic base (covering aerospace, energy, motor vehicles, pharmaceuticals, and other industries), and strong human capital (including young professionals who have returned from Poland after stints in Ireland the United Kingdom).

These assets bolster Poland’s capacity to attract foreign direct investment, a key determinant of sustainable growth as the short-term effects of fiscal stimulus programmes ebb. A July 2009 survey of international corporate executives conducted by the United Nations Conference on Trade and Investment (World Investment Prospects Survey 2009-2011) ranked Poland 13th in the list of the world’s leading destinations for foreign direct investment.

Modest growth: Czech Republic, Slovenia, Slovak Republic, Romania

The second group includes the Czech Republic, whose strong ranking in UNCTAD’s foreign investment survey (along with Poland the only CEE economies to place in the top 30 FDI destinations) underscores the pull of the country’s strong engineering base and skilled work force. Czech Republic’s capabilities in advanced manufacturing and favourable geographic locale make it a preferred site for Austrian, German, and Swiss multinationals seeking lower labour costs.

As the only EU-10 states to have entered the Euro zone by the time of the global financial crisis, Slovenia and the Slovak Republic are comparatively insulated from turbulence in foreign exchange markets. But Euro membership also denies those countries use of the exchange rate as an adjustment mechanism and constrains their ability to run fiscal deficits to spur growth.

Romania suffered one the region’s biggest GDP contractions in 2009 (8.5%), reflecting both the impact of the global recession and the suspension of capital flows to a country that was running an unsustainable current account deficit. The IMF projects mildly positive growth (0.5%) of the Romanian economy in 2010. But Romania’s large size and strong resource base indicate substantial scope for growth in coming years. By the IMF’s estimate, Romania will reach 5.0% GDP growth by 2014.

Economic contraction: Hungary, Bulgaria, Estonia, Lithuania, Latvia

Hungary, once one of post-socialist Eastern Europe’s best-performing economies, registered mediocre growth numbers in the pre-crisis years (1.2% real growth in 2007 against a regional level of 5.5%) before slowing to virtually zero growth in 2008 and then a 6.7% GDP contraction in 2009. Fiscal mismanagement, a shaky banking system, and an over leveraged household sector have eroded investor confidence in the Hungarian economy.

But Hungary’s large installed multinational base remains a significant competitive asset. Whether Hungary succeeds in leveraging that asset for sustainable growth hinges on the country’s ability to surmount a domestic political impasse that has long delayed structural reforms.

Bulgaria’s huge current account deficit (25.5% of GDP) left the country in a highly vulnerable position when the global credit crunch hit in fall 2008. The resultant fall in capital flows to Bulgaria forced a sharp reduction in imports that halved the external deficit. But this externally imposed adjustment also limits the growth potential of an economy that displays one of the European Union’s lowest per capita incomes and that requires Western imports to bridge the developmental gap.

The three Baltic states have suffered a dramatic reversal of fortune in recent years. Latvia was Europe’s fastest growing economy in the mid-2000s, posting 10-12% yearly growth rates. Estonia and Lithuania grew in the high single digits during the pre-crisis period.

But the combination of large current account deficits, excessive credit growth, and mounting housing bubbles precipitated an economic crash that dashed expectations of a soft landing in the Baltics. Estonia and Latvia were already registering negative GDP growth in 2008, and endured output falls of 14.0 and 18.0% respectively in 2009. The Lithuanian economy contracted by 18.5% in 2009, the steepest GDP decline of any European country and one of the biggest in the world.

Similar to Bulgaria, the Baltic Republics are undergoing an externally imposed adjustment that has narrowed their current account deficits. Indeed both Latvia and Lithuania posted current account surpluses in 2009, a trend that is expected to continue in 2010. As tiny, vulnerable economies operating in a newly constrained global capital market, the Baltic states have no choice but to enact deep import cuts to correct their external imbalances.

But that correction limits the Baltics’ access to the technology and equipment needed to modernise their economies and bridge the income gap with the wealthier CEE countries and Western Europe. IMF economists believe that it will take several years for the Baltic Republics to wind down their external imbalances and resume GDP growth. Furthermore, what economic growth rates Estonia, Latvia, and Lithuania do achieve in coming years will fall far short of the levels that earned them the title of "Baltic Tigers" in the early/mid 2000s.