Research & Investment Strategy

Central and Eastern Europe defying gravity?

Key points

  • Central and Eastern Europe (CEE) economies have proved resilient so far. They remain nevertheless sensitive to the slowdown in world trade, given their high degree of openness. They are highly dependent on trade with the euro area, particularly Germany, through the strong integration of the auto sector. However, sentiment in manufacturing is deteriorating.
  • While the region cannot remain immune to the global trade slowdown, domestic demand should cushion the deceleration in manufacturing. Consumer confidence remains strong – close to historical highs – on the back of structurally tight labour markets supporting strong wage growth and still-subdued inflation.
  • Public finances are sound and governments can provide further stimulus in case of abrupt slowdown. Abundant European Union structural funds should continue to translate into robust investment activity until 2020, although downside risks rise thereafter. Monetary policy should remain accommodative.

Economic activity proved resilient in CEE...

Recently-published flash estimates of GDP growth in Central and Eastern Europe (CEE) depict a rather supportive picture of economic activity in the second quarter (Q2) (Exhibit 1). Undoubtedly, the quarterly growth clip decelerated somewhat, but remained laudable with Poland up 0.8% quarter-on-quarter (qoq), the Czech Republic up 0.6% qoq, Hungary 1.1% qoq and Slovakia the weakest growth at 0.4% qoq. Slovakia’s sudden and more pronounced slowdown appears related to the drop in car manufacturing, as well as a partial shutdown at oil refiner Slovnaft in May and June and output cuts at Steel Corp's factory against a backdrop of a still-struggling steel industry across Europe.

Year-on-year (yoy), GDP for Slovakia runs at a growth rate of 1.9%, while the figure is 2.7% for the Czech Republic, 4.4% in Poland and 4.9% in Hungary. This is a striking difference to the meagre 0.4% yoy growth rate in Germany in Q2, showing a remarkable resistance to the slowdown in the eurozone (Exhibit 2).

… but for how long?

Central European countries are nonetheless exposed to the global trade cycle, showing a high degree of economic openness – with the exception of Poland, given its relatively large domestic economy – and have particularly strong ties to the German economy (Exhibit 3).

Central Europe has become an important German trading partner. Exports to, and imports from, these countries amounted to 9% of German GDP in 2018. This exceeds other large German trade partners such as China, France or the United States (6%, 5.2% and less than 4% of German GDP respectively, Source IMF).

Conversely, Germany is the most important trading partner for Central European countries. Trade with Germany accounts for roughly half of Czech GDP and 20% of Polish GDP. Therefore the current slowdown in Europe’s biggest economy does not bode well for the CEE region in the coming quarters (Exhibit 4).

Manufacturing slowdown in the making

Despite the apparent resilience, the global economic slowdown is already being felt in the region. Manufacturing activity is weakening across the board, particularly in June, suggesting a growing impact in Q3 bar an acceleration in industrial activity (Exhibit 5). Purchasing Managers’ Index data for July showed weak new orders across the board, but August business confidence ticked up on the back of improved business expectations.

Manufacturing activity accounts for a large share of CEE countries’ GDP: 20-23% of the gross value added in Czech, Hungary and Slovakia, and about 17% for Poland. The automobile industry is at the heart of this manufacturing activity, largely connected to the German car sector. More than 3.6mn cars were produced in these four countries, known as the CEE-4, in 2018 (Exhibit 6). 40% were produced in the Czech Republic thanks to domestic brand Skoda, but also car manufacturers such as Hyundai and Toyota. Slovakia produced 30% of the total due to the presence of Volkswagen, PSA and Kia Motors. German car producers, such as Volkswagen, Audi and Mercedes have plants in Hungary, while BMW has committed to start a new production line there as well.

Car production has become important for these economies and represents a large share in each countries’ industrial production – around 25% in the Czech Republic and 40% for Slovakia. What’s more, over 90% of cars produced in Hungary are exported, for the most part in to the euro area. As such, car production accounts for an important part of the labour market – hundreds of thousands of people are employed in the auto sector. In turn, the car industry accounts for 5-6% of the respective countries’ GDP, a figure that could double when adding the whole supply chain around the car producers. For example, there are more than 700 suppliers in Hungary.

Car production from CEE is exported predominantly to Europe, rather than the US or China, so Germany and the European Union (EU) are most important for these countries. The German auto industry is presently facing multiple challenges, ranging from global issues such as the trade war and the ongoing threat of US tariffs on autos and auto parts and the slowdown of the Chinese economy – car sales dropped in China in 2018 for the first time since the series began in 1997. There are also more sector-specific issues like the emergence of electric vehicles, new ways of commuting – autonomous driving or car sharing models - and increasing pressures to reduce CO₂ car emissions though fines, taxes and/or car model bans.

Admittedly, auto makers in the region have been operating with high capacity constraints lately, so the current slowdown may bring the industry to more reasonable levels before becoming a problem. Volkswagen’s factory in Slovakia, for example, is implementing various measures to increase its factory efficiency, which includes workforce reductions. Still, there are factory opening projects in the region. Last year, Jaguar Land Rover opened a €1.4bn plant in Slovakia. BMW has announced its intention to invest €1bn in Hungary in order to expand its footprint in Europe, and a new Opel plant will be built in Poland. The CEE countries are increasingly recognised as a primary location for investment by Japanese automotive companies – this year, the first annual Japan-Central Eastern Europe Investment Awards and Summit took place in Tokyo. Furthermore, the Brexit situation is making them look for alternative locations to the UK inside the EU. All in all, while there are clear concerns around the car industry for Germany, the CEE region does not seem to be going out of favour just yet.

Domestic demand support to continue

Furthermore, domestic demand is likely to remain robust. Retail sales have weakened in Q2 but labour markets remain tight and consumer confidence hovers around historical highs (Exhibit 7). Credit to households still runs at a strong and consistent 8-10% year-on-year growth rate.

Unemployment rates continued to fall after the global financial crisis and are today at historical lows – 1.9% in the Czech Republic, 3.4% in Hungary, 3.8% in Poland and 5.4% in Slovakia. By comparison, the eurozone unemployment rate reached 7.5% in June 2019. Indeed, the region is confronted with a structural shortage of workers, not an excess. Aside from low birth rates in the region which will have significant implications in the future, the CEE region has been facing a continuous exodus of workers to richer EU nations, which has caused a shortage of skilled labour and pressure on wage growth. It will be a challenge for these economies to maintain or advance the pace of productivity growth amidst elevated rates of skilled worker emigration. However, this will be necessary if these economies are to avoid rising inflationary pressure associated with faster unit cost growth as wages rise (Exhibit 8).

EU and national budgets supportive for now

Aside from a strong consumer backdrop, domestic demand is likely to be further supported by still-sizeable EU fund inflows which translate into robust investment activity. The EU allotted more than €300bn to the CEE-4 from its budgets since 2000, including €200bn in the current 2014-2020 EU budget, two-thirds of which has been spent on projects supporting economic progress towards average EU levels. Poland is at present the biggest net recipient of the EU budget. Since their accession to the EU, these countries have received support from the EU of an average of 2.5-4% of their respective gross national income every year (Exhibit 9).

This support is likely to fade in the future. The next EU budget will be calculated in the absence of the UK, which was the second biggest net contributor. Additionally, the EU has entered a series of confrontations with some of these countries regarding national decisions deemed to hamper the rule of law, as was the case with Poland and Hungary recently. The European Commission introduced new regulations to protect the EU budget in such cases of deficiencies in the rule of law in its member states, including the suspension of payments and reduction or even termination of legal financial commitments from EU funds. However, apart from these confrontations, the CEE-4 are likely to benefit less from the EU budget allocations in the next period (2021-2027) as their level of income per capita has increased closer to the EU average.

Nevertheless, public finances remain sound (Exhibit 10). Fiscal policy remains broadly supportive, while deficits and debt metrics are improving across the region.

  • Poland will hold a general election in October 2019. The Law and Justice party is likely to win an outright majority and pursue the current accommodative policy stance for another term. Since coming into power in 2015, the Law and Justice party has increased welfare spending towards families and pensioners. Additional promises ahead of elections have been announced. Yet the government is targeting its first balanced central government budget in 30 years - a small general government deficit of 0.3% of GDP – for 2020 thanks to one-off proceeds from the pension reform, 5G auctions and CO₂ permits sales.
  • Similarly, the Hungarian government is aiming for a limited deficit next year of 1% of GDP – below the 1.5% target set by the EU Convergence Programme – despite increased support to families and various tax cuts, on the back of higher revenue expectations. Furthermore, Hungary has set aside a reserve budget of 1% of GDP which offers a buffer in case of worse-than-expected growth. The state has delivered a reduction in debt to 70.8% of GDP last year from a peak in 2011 when public debt reached 80.5%.
  • The Czech budget has been in surplus since 2016 but is likely to shift to a small deficit from 2020-2022 due to expenditure commitments, namely raising pensions and civil servants’ wages and family benefits. The debt trajectory has been declining since 2012, reaching 32.7% of GDP last year, and may continue to fall – albeit at a slower pace thanks to primary balance surpluses.
  • Slovakia was aiming for a first-ever balanced budget this year and a small surplus for 2020. This may look ambitious given the ongoing economic slowdown. Still, public debt fell below 50% of GDP last year and should remain on a solid path.

All in all, while growth is likely to be less buoyant in the coming quarters, growth in the CEE region is likely to remain relatively strong thanks to firm domestic demand, supported by strong wage growth and sustained EU funds inflows until 2021. We expect GDP growth this year to average close to 4% in Poland, 2.5% in the Czech Republic, 4.5% in Hungary and 2.5% in Slovakia before slowing to respectively 3%, 2.2%, 3.3% and 2% next year. Domestic inflationary pressures may be partially curbed by the slowdown in activity. The fiscal situation is healthy with most budgets close to balance and public debt on good trajectories allowing monetary policy to remain accommodative. Central banks’ course of action will remain under the influence of the European Central Bank’s dovish stance.

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