CESEE outlook: strong growth amid rising risks

13 April 2018

At our annual Spring Seminar, wiiw economists presented the outlook for the region, including a focus on Western Balkan EU accession, Chinese influence, and the “semi-periphery trap”.

By Richard Grieveson, Julia Grübler, Mario Holzner and Roman Stöllinger

wiiw held its annual Spring Seminar on April 12th. The events brings together policymakers, the business community and economists interested in Central, East and Southeast Europe (CESEE). This year’s seminar coincided with wiiw’s 45th anniversary. The Spring Seminar follows on from our Spring Forecast report, published in March.

As usual, presentations were given by prominent external experts on the region, as well as by wiiw Economists. We were delighted to welcome Ivan Krastev and Jan Svejnar, as well as a panel of business experts. Four wiiw Economists presented on the outlook for CESEE in the next three years, Western Balkan EU accession prospects, China’s outreach to CESEE, and functional specialisation patterns in the region. Below, the four presentations by wiiw staff are summarised (the external presentations will be featured separately on our website).

CESEE in 2018-20: Riding the global growth wave

The global economic cycle is in a very positive phase, with its major motors—the US, China and the Eurozone—all growing strongly together for the first time in almost a decade. Particularly important within this is Germany, where growth is at a very high level in the post-crisis context. Germany’s trade and investment links with most countries in CESEE are extensive.

The implications of this for the region are highly positive. Last year CESEE recorded its best aggregate growth since 2011. For the first time since 2007, all 22 countries in the region covered by wiiw posted positive real GDP growth.

Although the peak of the cycle may have passed, we expect growth to remain robust at global, Eurozone, and regional levels. Most of CESEE will continue to converge with Western European income levels during our forecast period. Within CESEE, consumption will continue to expand, supported by positive trends in labour markets and rising real wages. Investment started to recover strongly last year, and we expect this to continue, underpinned by higher capacity utilisation, low interest rates, better confidence, EU funds inflows, and rising property prices. The external sector will also contribute, helped by strong competitiveness and a rising export/GDP share. Finally, banking sectors in much of the region are in a better position to support growth than has been the case for a decade.

In this context it is reasonable to ask whether the region is overheating. Our overheating index suggests that it is not, although pockets of risk exist, including in tight labour markets, rising property prices, and negative real interest rates. Nevertheless, credit growth is moderate, and few countries have fiscal and/or external imbalances. Inflation is starting to pick up, but remains at historically subdued levels, particularly in the context of labour market tightness. The countries where we see the greatest risk of overheating are Turkey and Romania.

Elsewhere, however, we see important risks to growth in CESEE, and these have increased recently. The most significant is the potential for a global trade war, which would hit the region hard. In addition, we are worried about East-West EU splits, threats to the rule of law in CESEE, and the fallout from Brexit. Areas where we see lower risks, but potentially a higher impact, are an unsafe exit from ultra-loose monetary policy at the global level, the bursting of financial bubbles, a renewed uptick in the Ukraine crisis, and a Eurozone break-up. Demographic decline brings a longer-term threat to growth, but we see the potential for automation to offset at least part of this.

Presentation 'CESEE in 2018-20: Riding the global growth wave' by Richard Grieveson

Western Balkan EU accession prospects

Until recently, the EU’s approach towards the Western Balkans focused on achieving stability via connectivity: the idea that economic integration and upgrading of infrastructure would bring about rapprochement in the various political conflicts in the region. In some ways, the implications of this have been positive: access to EU markets and higher FDI have seen an increase in the size of export sectors across the region.

However, the region remains plagued by a huge infrastructure deficit, which remains a barrier to per capita income convergence, even with the rest of CESEE. EU financial support in this regard is modest, particularly compared with EU-CEE countries. Political conflicts often act as a barrier to greater connectivity in infrastructure.

In recognition of this, the EU has changed tack. Its new strategy focuses more on solving political conflicts and security issues in the region directly, as a means of driving economic integration (rather than the other way round). We view this as a welcome change of approach. A target date for accession of 2025 has been set, although this might however be of a more of strategic nature.

This creates reason for optimism, but major challenges remain. The Western Balkan countries suffer from serious governance deficits compared with regional peers—Croatia, Bulgaria, Romania—at the time of their accession to the EU. Bridging this gap in eight years looks unrealistic to us. Moreover, the issue of whether accession will take the form of a “regatta” (countries join individually when they are ready) or an “express” (all join together) remains open.

Presentation 'Western Balkan EU accession prospects' by Mario Holzner

China’s outreach to CESEE

There are many motives for China to engage with CESEE as part of its “belt and road” initiative. The most important is developing a transport link between the Port of Piraeus in Greece (which Beijing has invested heavily in), and key Western European markets for Chinese goods. Moreover, the fact that CESEE countries are in need of investments and financing of infrastructure creates a valuable means for China to get rid of excess capacity in some of its industries, as well as creating the chance to “export unemployment”.

The benefits for CESEE are also potentially significant. For EU members in the region, Chinese investment plans are dwarfed by EU grants (which also do not need to be paid back, as Chinese loans do), limiting their importance. However, they are much more significant in Western Balkan countries, which have only limited access to EU grants.

For the region as a whole, any support in upgrading infrastructure is welcome: According to the EBRD Transition Report 2017-2018, infrastructure investment needs range from around 2% of GDP per year for the Czech Republic to more than 12% per year for Bosnia and Herzegovina. However, this is particularly the case in the Western Balkans. wiiw research has highlighted deficits in motorway and railway density in the region, as well as a scarcity of powerful electricity lines.

Nevertheless, benefits for CESEE from Chinese investment are not certain, and will depend whether local contractors, suppliers and particularly workers will be able to participate in implementing envisaged projects. In a worst-case scenario, where infrastructure projects are implemented solely by Chinese companies and workers, medium to long term positive income effects for CEE would dwindle. Further, this could aggravate existing concerns about the sustainability of debt in the region. Finally, non-existent or non-transparent tendering processes for public investments could fuel corruption – a barrier to economic growth and convergence that the region has already been fighting against for a long time.

Presentation 'China’s outreach to CESEE' by Julia Grübler

Change in functional specialisation patters

Over the past decades, the economies of Central, Eastern and South Eastern Europe (CESEE) have been remarkably successful in catching up with the ‘old’ EU Member States in terms of income per capita. Despite some setbacks during the Great Recession and a slowdown in the convergence process, the most advanced countries of the region have attained a GDP per capita level of more than 80% of the EU average. A plethora of interrelated factors have contributed to this development, but one of the most obvious support factors has been foreign direct investment (FDI). The question is whether this convergence process will continue, given the position these countries occupy in international production networks and the income levels already attained.

Foreign capital has flown in mainly from wealthier EU member states, and has brought new technologies and organisational capabilities. The emergence of twenty-first-century trade meant that the investment activities of multinational enterprises (MNEs) induced a structural convergence between the initial industrial core countries of the EU and the New Member States (and to a lesser extent the Western Balkan region) as they were integrated into European production networks.  International value chains are a defining feature of this integration process, which has meant that the international division of labour has become much more granular. In particular, countries no longer specialise only in certain industries (i.e. the structural component), but are also assigned certain functions along the firm’s value chain (i.e. the functional component).

CESEE countries now face the risk of becoming the EU’s permanent semi-periphery. They have developed a very strong specialisation along the value chain in the actual production process, which is associated with relatively little value creation (compared to research and development [R&D] and headquarter services, for example). This type of specialisation could become a ‘functional trap’ for several CESEE countries, meaning that the region risks ending up as a permanent semi-periphery with a high degree of economic dependence on the Western core EU countries, and income levels never reaching those of the leading economies.

Presentation 'Change in functional specialisation patters' by Roman Stöllinger