WIIW The Vienna Institute for International Economic Studies - Wiener Institut für Internationale Wirtschaftsvergleiche

By Marcus How, Head of Analysis at VE Insight

image credit: istock.com/MicroStockHub

• At the beginning of 2022, political risks in CESEE were regionally at their highest since the 1990s.
• Global economic trends such as high inflation are impacting on the prices of basic goods and utilities, increasing the potential for political and social instability.
• Domestic developments in individual states in CESEE are having increasing spill-over effects inside the region, reflecting its geopolitical interconnectedness.
• This is partly due to competition in the region between major stakeholders such as the US, Russia, China and the EU, but also growth in the relative strategic autonomy of other states, such as Hungary, Serbia and Turkey.
• In 2022, political risks in CESEE will be shaped by, but not limited to, three strategic trends:
• First, the high probability of targeted military action by Russia in Ukraine, as Moscow seeks to coercively constrain the security apparatus of its neighbour, while consolidating its strategic influence vis-à-vis NATO and China.
• Second, the greater likelihood of institutional failure (and possibly armed conflict) in Bosnia and Herzegovina, reflecting the failure of the US and EU to respond adequately to strategic challenges in the Western Balkans, which is hosting an increasing number of competing interests.
• Third, the increased chance that ‘illiberal’ incumbents will be defeated in elections in Hungary and Slovenia, fundamentally altering the balance of power in the EU, even as their multiparty successors struggle to govern effectively.
• Other strategic trends not included in this analysis include the politically inflicted crash of the Turkish lira; the deterioration in relations between China and Central and Eastern European states such as Lithuania and Czechia; and the limited impact of liquefied natural gas in reducing energy dependence.

1. War risks: Russian wargaming in Ukraine and the CIS

War risks in CESEE are at their highest since 2014, as Russian President Vladimir Putin seeks formal guarantees as to the geopolitical contours of the former Soviet space and Eastern Europe more generally. First, Moscow wishes to force the implementation of the Minsk peace agreements on Ukraine, which, under the presidency of Volodymyr Zelensky, it believes is becoming a permanently hostile neighbour.

Over the past year, the Zelensky administration has taken considerable steps to develop Ukraine’s relative strength vis-à-vis Russia, further modernising its military capabilities through the acquisition of weaponry from NATO members, such as the US, UK and Turkey. Moscow fears that this may facilitate a Ukrainian offensive against separatist forces in the breakaway territories of Donetsk and Luhansk, and also that Kyiv may acquire military capabilities with which it can target Russian cities.

Second, Moscow seeks a wider renegotiation of security arrangements within Central and Eastern Europe, demanding that NATO commit to curtailing its deployments within the territories of its easternmost members, while expanding no further.

Moscow has employed coercive diplomacy to this end, signalling its willingness to use force as a last resort by amassing at least 100,000 troops along the Russian border with Ukraine. Multiple battalions have also assembled to conduct wargames in Belarus: this previously neutral territory has emerged as a possible northern front from which direct attacks on the Ukrainian capital, Kyiv, could be launched.

Many of the items tabled by Moscow in the negotiations with NATO in Geneva can be traded away. NATO expansion itself is a distraction, as the neighbouring states of Russia that are not in NATO – including Ukraine – are not going to join in the foreseeable future. Precluding Ukrainian membership also changes little for NATO in substantive terms. Yet while Washington may admit this privately, it cannot do so publicly without losing face – just as Moscow cannot walk away with assurances that it cannot sell to an audience, be it domestic or international.

Regardless, the short timeframe that Moscow has imposed on NATO to reach an agreement indicates that a grand security bargain is unlikely. The rush is to force concessions that will stunt Ukraine’s security apparatus in the medium to long term. The longer Moscow waits, the stronger Kyiv may become, with the Kremlin expressing particular concern that it will ultimately acquire the capability to launch long-range missiles that could reach Russian cities.

If Moscow cannot secure credible guarantees, it may decide to resort to force, striking first to prevent such a scenario – as well as to forestall the prospect of a stronger Ukrainian offensive in Donbas. A full-scale land invasion of Ukraine is unlikely because, even if Russian forces could achieve a swift victory, the cost of containing a deeply hostile population over a vast territory would be very high in the medium and long term. That could increase the risks of civil unrest and political instability in Russia, where polls suggest that the public, weary of stagnating living standards and dysfunctional local services, is divided on the prospect of war.[1]

Targeted, limited action is more likely, designed to inflict significant damage on Ukrainian defence capabilities, increase Moscow’s negotiating leverage vis-à-vis Kyiv and destabilise the Zelensky administration. This could be accomplished through a variety of means, such as the use of Russia’s superior long-range artillery capabilities and/or the launching of a ground offensive in the direction of Kyiv. Moscow will not necessarily act immediately: it could potentially wait until spring for the Omicron wave of the COVID-19 pandemic and the Beijing Winter Olympics to pass.

Fresh rounds of sanctions from the US, UK and EU are very likely to follow, while the rouble is expected to depreciate by as much as 20%. Nonetheless, the Russian economy has considerable cushioning, with the central bank having accrued some USD 630bn in foreign reserves, up to USD 175bn more than in 2014.[2]

Furthermore, the EU remains unwilling to match its sanctions regime with that of the US. Both have discounted the possibility of removing Russia from the SWIFT payments system in the event of an escalation in Ukraine, which would be the severest of options. The Biden administration has even gone so far as to distinguish between different types of military action (‘minor incursions’), suggesting that there would be a spectrum of options for sanctions. But while the US would very likely target major Russian banks, EU member states such as Germany are hoping to soften any such action by exempting certain banks and transactions (such as payments for oil and gas).

It is therefore questionable whether sanctions would inflict the necessary damage on Russia to disincentivise military action. This extends to project risks, specifically around the Nord Stream 2 gas pipeline. The willingness of Germany’s new ‘traffic light’ coalition to suspend Nord Stream 2 (which is awaiting regulatory approval) indefinitely is as unclear as it was under the previous government. If it finds itself obliged to proceed with the suspension, natural gas prices in Europe will spike further.

The real risks to the Russian economy will more likely manifest themselves in the medium to long term, as its competitiveness and diversification stagnates further in the deepening absence of foreign direct investment. This trend of stagnation has been under way since at least 2014, perpetuated by international sanctions, restrictive monetary and fiscal policy, and institutional weakness. Nonetheless, Moscow is currently in as strong a position as it is ever likely to be with respect to extracting concessions over Ukraine and NATO, whether diplomatically or militarily.

Yet its wider strategy is not limited to merely pacifying Kyiv. The formalisation of its geopolitical influence provides a foundation from which Russia may emerge as a strategic wedge between the West and China, shifting between alliances of convenience. This has partly informed Moscow’s interventions to prevent the overthrow – whether by popular protest or palace intrigue – of the administrations of Alexander Lukashenko in Belarus and Kassym-Jomart Tokayev in Kazakhstan. It is not just about preventing ‘colour’ revolutions: there is also geopolitical value in maximising strategic leverage.

There are many differences between Belarus and Kazakhstan – not least in relation to the events that prompted Moscow to intervene. But where the two countries are similar is that both have conducted their external relations since 1991 on an increasingly multi-vectoral basis, despite being important allies of Russia. This reflected the strategic autonomy that Alexander Lukashenko and Nursultan Nazarbayev (Tokayev’s predecessor as president) cultivated.

In the wake of Moscow’s intervention, Belarus has effectively become a vassal state, sustained by rationed financial support. This has already paid dividends as far as Moscow is concerned, with Lukashenko reversing his erstwhile refusal to recognise the annexation of Crimea and to permit Russian military bases (and even the deployment of nuclear weapons) in Belarus. Indeed, the country has ended up informing the security strategy of Moscow in Europe to such an extent that the trajectory of domestic events in Belarus has become largely dependent on external actors.

Kazakhstan is not in the same situation, but Moscow did help Tokayev consolidate his tenuous hold on power at the expense of the faction of interests surrounding Nazarbayev. The stability of the Tokayev administration is not necessarily dependent on Moscow; but the latter proved itself a powerful ally, should it ever be needed. In this sense, the Tokayev administration is likely to coordinate with Moscow more closely on foreign policy, potentially facilitating greater interdependence. This, as opposed to creeping annexation, is a cost-effective means by which Moscow can consolidate a strategic bloc.

2. Geopolitical risks: Paralysis in the Western Balkans

The Western response to a Russian escalation in Ukraine could be hamstrung by political instability in the Western Balkans. This might be violent in nature, with Bosnia and Herzegovina experiencing armed conflict for the first time since the 1990s as Republika Srpska – one of its two autonomous entities – threatens to initiate secession from state institutions.

The current standoff was triggered in 2021 by the outgoing High Representative for Bosnia and Herzegovina, Valentin Inzko, imposing legal changes to ban genocide denial. In response, the long-time leader of Republika Srpska, Milorad Dodik, ordered a boycott of state institutions by Republika Srpska officials, at the same time taking steps to create separate judicial, regulatory, tax and military bodies.

The West was slow to respond to these acts, with the Biden administration only announcing sanctions against Dodik and his close associates in January 2022; meanwhile, the EU has so far failed to agree on sanctions, due to the opposition of Hungary. The Republika Srpska leadership in Banja Luka is evincing a willingness to discuss an end to the boycott; but whether this will actually materialise is uncertain.

Even if the boycott is lifted, it will remain a symptom of a deeper institutional paralysis in Bosnia and Herzegovina – one that is eroding the functionality of the state in its current form. The representatives of the Bosniaks, Serbs and Croats who make up the country have repeatedly failed to pass electoral reforms. These are technically necessary ahead of the national elections that are scheduled for 2 October, but they are being delayed by Croat politicians, who are demanding that Bosniaks should be barred from voting for Croat candidates; in this they are supported by Banja Luka.

If electoral reforms are agreed, it will be a positive indicator; but they will likely reflect the entrenchment of ethnic divisions. If the reforms fail to materialise, voting could technically still proceed on the basis of by-laws, which was the case in the 2018 election – but the participation of Croat and Serb representatives could not be guaranteed. An alternative would be for the ruling parties to continue to govern on a technical mandate. There is a precedent for this at the local level: elections were not held in Mostar for 12 years.

Yet in the absence of a consensus, the risks of institutional failure – and even violent secession – will remain elevated. Armed conflict would be different to 1992, when the Serb minority actively seized territory to carve out its enclave, using heavy armour and other weaponry that it no longer possesses. However, the situation could escalate quickly, as the Republika Srpska police are relatively militarised and the Bosnian army is divided into ethnically homogeneous battalions. A likely flashpoint would be Brčko District, an autonomous unit that disrupts the territorial continuity of Republika Srpska.

Something that could increase the likelihood of armed conflict would be a military escalation in Ukraine. Moscow actively supports Banja Luka and could encourage unilateral action, concurrently precipitating a second security crisis for the West.

But Russian influence is just one factor among multiple competing interests in the Western Balkans. The geopolitical – and therefore economic – trajectory of the region is unclear, given that the EU accession process has stalled. There are three reasons for this. First, the unanimity required by EU member states on the enlargement process belies a deeper ambivalence over whether it should continue at all. After French President Emmanuel Macron demanded reforms to the process, in order to effectively increase conditionality, domestic political considerations in Bulgaria prompted Sofia to block the formal launch of EU accession negotiations with North Macedonia, whose membership application is coupled with that of Albania.

The prolonged uncertainty resulted in the resignation of Zoran Zaev as North Macedonia’s prime minister, after his party was defeated in local elections in October. Three parliamentary elections in Bulgaria in 2021 ultimately resulted in a reformist government committed to finding an agreement with Skopje over the cultural issues that provided the basis for the veto. The applications of North Macedonia and Albania are likely to proceed, but nonetheless it is all rather symbolic, as the institutional reforms necessary for EU membership will take at least a decade – assuming they are enacted at all.

This informs the second reason for the stalled accession process: namely, that candidate states are instituting reforms that, while notionally adequate on paper, are largely hollow and vulnerable to abuse by powerful informal interests. The most problematic candidate in this respect is Serbia, where institutional power has been captured by President Aleksandar Vučić and his proxies in the intelligence services.

The third reason is that the territorial status of Serbia and Kosovo (and effectively that of Bosnia and Herzegovina) remains unresolved. In Kosovo, the formation of a majority government by Albin Kurti’s Self-Determination Movement in 2021 prompted a change in approach that has widened the bilateral differences. For as long as the stalemate persists, it will be virtually impossible for either Serbia or Kosovo to join the EU. Moreover, the deadlock will prevent the formation of the Western Balkans as a unified economic bloc in its own right.

This status quo is creating a vacuum may be exploited by competing interests. Besides Russia, China has emerged as a strategic actor, even if the scale and success of its engagement is overstated. Meanwhile, Hungarian Prime Minister Viktor Orbán’s hard-right government is blocking EU sanctions against the Republika Srpska leadership, and it has pledged EUR 100m in funding for the Republika Srpska entity. The influence of Budapest is modest in absolute terms, but in recent years it has exploited the delicate balance to bolster its own interests, both politically and economically.

The absence of progress in the accession process has also enabled Belgrade to position itself as a regional leader, emerging as a hub for foreign investments that are facilitating its integration into EU value chains, while simultaneously deepening its diplomatic and economic relations with China, Russia and the Arab states. Belgrade is now pioneering its own regional initiatives, such as the Open Balkan initiative, which aims to create, together with Albania and North Macedonia, a ‘mini-Schengen’ area, in which labour and capital may move freely – but outside the Berlin Process driven by the EU, thus excluding Kosovo, Bosnia and Herzegovina and Montenegro, as well as the customs union that it envisages.

In this sense, armed conflict is not in the interests of Belgrade, despite its willingness to exploit the political divisions of its neighbours, while its corporate interests acquire stakes in their multimedia and telecoms sectors.

3. Political instability: Elections in CESEE

Five national elections are scheduled to be held in CESEE in 2022: in Hungary, Serbia, Slovenia, Latvia and Bosnia and Herzegovina. The results will be of great significance to the balance of geopolitical power within the EU, as there is a possibility that the ‘illiberal’ bloc could face defeat in Hungary and Slovenia. Serbia is holding presidential, parliamentary and local elections concurrently on 3 April; regime change is unlikely, but the opposition forces will potentially be able to score symbolic victories, such as in the Belgrade mayoral election. Poland and Turkey also face an increased likelihood of snap elections in 2022, owing to the political instability that is undermining their respective illiberal governments.

On 3 April, Viktor Orbán’s alliance of Fidesz and the Christian Democratic People’s Party (KDNP) will compete for its fourth consecutive term in office. Over much of the past decade, Fidesz-KDNP has commanded a two-thirds majority, enabling wholesale structuring of the constitution to reflect its illiberal nationalism. In practice, this has centralised power with the Prime Minister’s Office, be it directly or indirectly. International indices show that institutional checks and balances have been systematically undermined, including judicial independence, democratic oversight and media discourse. Corruption has also increased considerably, with the public-private divide blurred by an oligarchic class that has privileged access to public resources, such as contracts.

Despite the hegemony that Fidesz-KDNP has established, the upcoming election will be the most hotly contested since 2010. The reason is that six opposition parties – ranging from the centre-left Democratic Coalition to the right-wing Jobbik – have set aside years of feuding to form a single national list and to field single candidates for an alliance called United for Hungary. Such cooperation proved successful in the 2019 local elections, when opposition pacts secured victories in multiple cities across Hungary, including Budapest. United for Hungary is also fielding a single prime ministerial candidate, Péter Márki-Zay, a centre-right political outsider who was elected in open primaries. The opposition will focus on themes such as the mismanagement of the COVID-19 pandemic and the high levels of corruption.

In order to win an absolute majority in parliament, United for Hungary will need to secure 5% more of the vote than Fidesz-KDNP, which has a structural advantage owing to distortions in the electoral system. Average opinion polling currently indicates that United for Hungary has lost the momentum it accumulated after the autumn primaries.[3] The challenge is compounded by the capture of nearly all the major media by Fidesz-KDNP, as well as by the propensity of the opposition parties to engage in infighting.

Nonetheless, it is very likely that Fidesz-KDNP will lose its two-thirds majority in parliament. If United for Hungary should win, the result would be of major symbolic significance both within Hungary and in the EU. For example, suspending the voting rights of member states that violate the rule of law – such as Poland – would become considerably easier.

However, political instability in Hungary would increase, since the opposition alliance would immediately be hamstrung by the fact that Fidesz-KDNP has embedded many policy areas in the constitution. Meanwhile, annual budgets must be approved by the National Fiscal Council, whose three members were appointed indirectly by Orbán for nine-year terms and cannot be dismissed. If it rejects the annual budget, a snap election may be triggered automatically.

Given these obstacles, United for Hungary is still not in agreement on whether to enact changes in the modest number of areas that are outside the purview of the constitution; rewrite the constitution and submit it to a referendum; or simply override it. This will create considerable legal uncertainty, even as United for Hungary struggles to reconcile its pledge not to increase taxes with the need to reduce a structural budget deficit worth 8% of GDP.

The case of Hungary illustrates the challenge that broad alliances have in governing if they can win elections in illiberal, semi-authoritarian systems. This is partly due to institutional obstacles erected by incumbent interests; but it is equally attributable to the diverse nature of the alliances themselves, which are formed on the basis of a lowest common denominator, and which draw together a plethora of ideologies and vested interests, as well as personal rivalries.

In Montenegro and Slovakia, where multiparty opposition alliances succeeded in defeating entrenched incumbents in 2020, progress in implementing reforms has been slow, with the newly victorious majorities descending into destabilising squabbling almost immediately. In Romania, where a reformist coalition was formed in 2021, the protracted disputes between the coalition partners became so bitter that the National Liberal Party instead opted to form a grand coalition with the Social Democratic Party – the very institutional force it was seeking to dislodge.

Such paralysis perpetuates voter disaffection and increases the risk of populism and backsliding. In Slovenia, Janez Janša’s Slovenian Democratic Party is likely to emerge without partners following the parliamentary election on 24 April; but the four-party centrist alliance that is seeking to replace it has a record of instability, raising doubts as to whether it can govern effectively. In Czechia, the new five-party centre-right coalition, which comprises mostly establishment parties, will risk its popularity as it attempts deep fiscal consolidation. Yet the populist vote is large and it only failed to carry the 2021 election because of its fragmentation across parties.

Governments such as these are like minority administrations, in that they must painstakingly negotiate each policy item. There are few states in CESEE where the opposition appears in the form of a unified political movement. And even where it does – namely in Kosovo and Moldova – any new government will find its freedom of action constrained by external factors, not least larger neighbours.

Slovakia also demonstrates that within the EU, the risk of sanctions is not neutralised by regime change: the government there has struggled to introduce those changes on which its full receipt of EU recovery funds depends, such as reforms to its courts and universities. Thus, the current opposition forces in those member states that are deemed by the EU to be institutionally compromised – such as Hungary and Poland – would, if they came to power, have to contend with conditionality just as much as the current illiberal incumbents, who are facing delays in the payment of EU stimulus funds.

Yet payment risks are only a short- to medium-term factor stemming from political paralysis, populism and suboptimal governance. In EU-CEE, economic models based on foreign direct investment and the export of finished and intermediate goods to higher-value markets are reaching their limits. In order to compete on the global market in the long term, governments will need to develop industrial policies that facilitate innovation, in the process reforming education systems to upskill the labour force and facilitating research and development.[4] This impacts EU-CEE most immediately; but other emerging markets – from Russia to the Western Balkans – face similar challenges.

This all ties in with another strategic challenge: namely, the ability to halt the demographic decline, which recent censuses in Bulgaria and Croatia have shown is deeper than was thought. This does not necessarily entail a future of low growth, as structural trends such as automation are strong mitigating factors.[5] But institutional stagnation and backsliding – and the concomitant populism and political instability – are unlikely to be meaningfully reversed until the exodus of labour and skills is adequately tackled.

 

[1] https://www.levada.ru/en/2021/04/16/ukraine-and-donbas/

[2] https://www.cbr.ru/eng/hd_base/mrrf/mrrf_7d/?UniDbQuery.Posted=True&UniDbQuery.From=01.2012&UniDbQuery.To=01.2022

[3] https://www.politico.eu/europe-poll-of-polls/hungary/

[4] https://wiiw.ac.at/avoiding-a-trap-and-embracing-the-megatrends-proposals-for-a-new-growth-model-in-eu-cee-dlp-5987.pdf

[5] https://www.oenb.at/dam/jcr:02851c10-fcbb-4d1f-b056-5095d246e2dc/11_Demographic_decline_feei_2018_q3.pdf