Opportunities and Risks for the Economies of Central Europe

15. 3. 2017

Out of the eleven countries of the region which are members of the European Union only the Polish government declares that it does not intend to join the eurozone.

Over the eleven years of European Union membership, the countries of Central and Eastern Europe (CEE) have achieved good economic results. Poland and Slovakia were the fastest-growing countries in Europe and almost doubled their GDP. The Czech Republic and Hungary fared slightly worse, but they also developed faster than Western Europe. All countries in the region absorbed billions of dollars in annual direct investments, as well as EU funds, which enabled them to build new motorways, airports, modern railway lines. Nevertheless, the economies of these countries are not free from problems.


The economic growth in the countries of Central and Eastern Europe accelerated last year. The fastest-growing countries in the region were: the Czech Republic, Poland, Romania, and Slovakia. They increased their capital expenditures. In Hungary and Slovenia investment growth decreased, which resulted from the completion of large investment projects, including those financed from EU funds.

In Romania, important factors boosting the dynamics were tax cuts and increased spending on welfare leading to consumption growth. In Bulgaria and Croatia the rise of private consumption, as well as of investments, was inhibited by large private and government sector debt and by the instability of the banking system.

Also the Baltic economies, especially Estonia and Lithuania, were growing at a slower rate, which was caused by the recession in the neighboring countries—Russia and Finland.

Financial markets of the EEC countries remained resistant to negative global events. As a result, interest rates on sovereign debt were decreasing and in the Czech Republic bond yields fell below the German levels. Investors perceived the region as a “safe haven” for their capital.

The fall in commodity prices on world markets, especially of oil and natural gas, had a positive impact on the competitiveness of the EEC countries’ exports and supported the growth of domestic demand. Inflation fell almost to zero, and in some countries deflation appeared. The drop in prices was the strongest in Bulgaria, Romania, and Slovenia. The highest increase in prices occurred in Hungary—by 0.9%.

Foreign investors are not convinced about the sustainability of the recovery in Europe and therefore they did not start new investments also in the CEE region. The car industry was an exception last year. International corporations decided to build or expand their plants in, among others, the Czech Republic (Volkswagen). The construction of a Jaguar Land Rover factory in Slovakia and Daimler in Hungary is also planned.

The Outlook

International institutions (IMF, European Commission, OECD) predict that in 2016-2017 the growth rate in the CEE countries will remain at a level close to that achieved in 2015. Further improvement in the labor market situation is prognosticated, which also means consumption growth. At the same time, an accelerated growth of salaries and low inflation can be expected, although the specter of deflation will disappear within one year.

In some countries the growth of budget deficit is predicted, in the short term conducive to the growth of consumption and GDP. In Romania it will result from tax cuts and in Poland from increased government expenditure.

The investment dynamics will decrease as a result of a slowdown in public investments and temporarily lower absorption of EU funds.

The biggest threat for economic growth could be the slowing of exports, resulting from restrictions in the free movement of goods within the Schengen zone. The migration crisis may have a negative impact on the situation in most economies of the region. The Czech Republic, Slovakia, and Hungary could be the most affected, as they are the most open to foreign trade and the most incorporated into European production networks.

Also the Volkswagen emissions scandal may negatively influence the economies of these three countries. The Volkswagen group factories in the Czech Republic, Slovakia, and Hungary belong to the largest enterprises in these countries. The deepening recession in Russia may be a threat to the Baltic countries.

Challenges and Weaknesses of the CEE Economies

The countries of Central and Eastern Europe differ in many aspects. Poland, the largest of them, has 38 million people and its GDP in current prices was at €714.5 billion in 2014. The smallest countries, Estonia, Latvia, and Slovenia have a population of 1,3, 2.1, and 2.1 million respectively and in 2014 generated a GDP of €27.5 billion, €34.9 billion, and €46.6 billion. The Czech Republic is the richest in terms of per capita GDP. In 2014 it achieved 85% of the EU average. Bulgaria, the poorest country in the region, has not yet passed the 50% mark.

Despite these differences, the CEE economies face many similar problems and challenges.

Almost all of them (perhaps with the exception of Poland) are small, open economies dependent on foreign trade and foreign capital, and hence on the external situation. International investment standing (that is the balance of foreign assets and liabilities) is negative in all CEE countries, which means that the inflow of foreign capital, in the shape of direct investment or loans for private and public sector, had a significant contribution to the growth of the economies. Small size combined with inflow of foreign capital means that the CEE countries have trouble with conducting an independent monetary policy. The three small Baltic countries and Bulgaria are the best examples of that. Their joining the European Union produced a huge (for their size) wave of foreign capital, which resulted in a rapid GDP growth and then an economic collapse, when in 2008 capital started to withdraw from countries considered more risky.

Problems with conducting a sovereign monetary policy are the most important argument for joining the eurozone by the CEE countries. Out of the eleven countries of the region which are members of the European Union, five (Estonia, Lithuania, Latvia, Slovakia, and Slovenia) belong to the eurozone. Only the Polish government declares that it does not intend to join the eurozone, even in a longer term.

A few countries of the region had and still have serious problems with mortgages denominated in foreign currencies. Rapid growth of such loans lasted until the outbreak of the global prices. Foreign currency loans exposed the banking systems of several countries to the risk of instability. Hungary was in the most difficult situation, as foreign currency loans constituted 56% of all credits in 2007. The law adopted in June 2014 obligated the banks to refund customers the profits, accumulated since 2004, from inflated interest rates and exchange rate spreads, which cost banks €2-3 billion, that is about one third of their equity. In October 2014, Hungary adopted a law which completely eliminated household loans in foreign currencies.

In Poland, the problem of foreign currency loans (largely denominated in Swiss francs) is less painful than in Hungary, but the president’s proposal to make it possible for customers to repay their mortgage at the so-called “fair exchange rate” may destabilize the banking system.

All CEE countries have a poor demographic situation, which is exacerbated by emigration to Western Europe.

Their relatively rapid economic growth was based on exploiting simple reserves (cheap labor force, transition of workers from low productivity sectors to more efficient ones). But this strategy is exhausting its possibilities. The CEE countries have overtaken or are catching up with the poorest countries of “old” Europe, that is Greece and Portugal, but the prospect of catching up with richer countries, such as Germany, seems remote.

Attempts at a New Strategy

In April 2010, Hungarian elections were won by the Fidesz party (which repeated its victory four years later) and Victor Orbán became prime minister, his government attempting to conduct an unorthodox economic policy, not always accepted by the European Union. Hungary refused to receive the next tranche of the International Monetary Fund loan, as it would mean the necessity to comply with the IMF recommendations.

Hungarian public finances sector has been partly balanced thanks to overtaking pension fund savings by the government, as well as to raising taxes. Tax revenues increased from 44.3% of GDP in 2011 to 47.4% in 2014. Income tax was reduced, but VAT was raised to 27%, that is the highest level in the European Union.

The government of Hungary introduced special taxes which were to affect only companies in selected industries, dominated by foreign capital. The first “sectoral” taxes were imposed in 2010. They were paid by banks, the energy sector, telecommunications, and large retail stores. They were in force until 2012, to be replaced in the following years by other taxes (on financial transactions, Internet and cable TV, unhealthy foods, advertising revenue, detergents, and so on).

The government supported investors (including foreign ones) in the processing industry and especially in the car industry—it agreed to participate in constructing the Audi factory in Gyor.

Since 2011 a program of public works has been in force. The unemployed who want to keep receiving the benefits after 180 days since losing their job have to take part in public works for at least four hours a day. The program led to a significant decrease in unemployment rate. The Hungarian National Bank (MNB) conducted an unconventional monetary policy. In 2012-2014 interest rates came down by almost 5 percentage points. In order to support investment by small and medium enterprises, the MNB introduced the Funding for Growth Scheme (FGS)—it offered interest-free loans to commercial banks which passed these resources on in the form of low-interest credits (up to 2.5% a year). In September 2013, the MNB decided to increase the scope of the program to HUF 1 billion (approximately 3.5% of the GDP). Over one third of all these funds went to businesses connected with agriculture. Despite the FGS, loans for the private sector were reduced as a result of the difficult situation of the banks, burdened with the costs of converting mortgages.

Other negative processes also appeared. Sectoral taxes discourage from investment in the services sector. Economic instability resulting from frequent changes in regulations does not motivate entrepreneurs to expand their businesses. The greatest achievement of Orbán’s policy was reducing the Hungarian economy’s dependency on foreign capital. Hungary’s international investment standing improved, although it is still the lowest among the CEE countries. This improvement resulted from a major surplus on the current account achieved by Hungary in the last three years, as well as from low interest rates on global markets. In 2014, Hungary boasted the highest growth rate among the CEE countries— 3.6%, but in 2015 it went down to 2.9%.

Meanwhile Poland, which until 2015 conducted a very balanced economic policy, in the last two years fared no worse than Hungary. In 2014 the GDP growth was 3.4% and in 2015 it was 3.6%. Unemployment rate is similar in both countries. Despite the cautious monetary policy by the central bank, bank loans for the private sector in 2015 increased by about 7%, while in Hungary they declined at a similar rate.

In a longer term Polish results are clearly better than the Hungarian ones. In 1990, Hungarian per capita GDP was 20% higher than in Poland, while now they are at a similar level. It is therefore difficult to understand why the new Polish government, formed by PiS (the Law and Justice party won the October 2015 elections) regards Hungary as a model of good economic policy and intends to introduce a number of Hungarian solutions, including sectoral taxes, which the Hungarians are gradually withdrawing from. The banking tax introduced in January 2016 is meant to partially finance the party’s social program (PLN 500 for every second and successive child up to 18 years old). In 2017 this program will cost about PLN 23 billion and to finance it the government will have to impose other sectoral taxes and/or increase existing ones, which in a longer term will dampen the economic dynamics.

Witold Gadomski

is an economic commentator for Gazeta Wyborcza. He specializes in economic matters. Earlier, he was the editor-in-chief of Cash weekly and of Nowa Europa daily. In the 1980s, he collaborated with opposition papers. At the beginning of the 1990s, he was a co-founder of the Liberal Democratic Congress party, headed by Donald Tusk. He is the author of the book “Leszek Balcerowicz”, and co-author of “Capitalism. Facts and Illusions”.

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