UniCredit Economics & FI/FX Research:
Differences in CEE grow, Central Europe could maintain growth advantage in 2015
• Given faltering recovery in eurozone and feeble global trade, domestic demand is crucial for CEE growth, reforms vital
• Conflict in Ukraine has limited indirect impact on CEE foreign trade, demand from the eurozone remains the key factor for CEE exports
The faltering economic recovery in the eurozone and the weak global trade will continue to widen the differences between the individual countries of Central and Eastern Europe (CEE) in 2015. Reform-minded economies in particular should grow this year, while states with clear structural problems will be in recession. This is the key message of the latest "CEE Quarterly", which is published every quarter by UniCredit Economics & FI/FX Research and is devoted to economic activity in the region. Central Europe and the Baltic states stand out from the crowd once again with their broad recoveries, better tax rate metrics and reliable external financing capabilities. All told, the economy in Central and South-Eastern Europe should grow this year by 2.5 percent, and by 2.9 percent in 2016, while the figures for the entire region will be 0.2 and 2.2 percent due to a contraction in Russia.
Limited stimulus from global exports
In contrast to the beginning of 2014, net exports are currently more of a burden in many CEE countries than a driver of economic growth. This is because stronger domestic demand prompts an increase in imports, while the faltering recovery in the eurozone, weak demand from other emerging markets and the conflicts in Ukraine and the Middle East constrain exports. These factors are also responsible for global exports growing by just 3 to 4 percent per annum in 2015 and 2016.
"Against the background of low export growth, price competitiveness is gaining in significance. In this context, the depreciation of the euro against the US dollar could provide some temporary support for CEE exports outside the EU. Were this to be insufficient, CEE countries could weaken their currencies with flexible exchange rates to the euro in order to loosen monetary policy", says UniCredit economist Dan Bucsa. In the long term though, the economies of Central and Eastern Europe must develop into more sophisticated production locations with higher added value. Looking at capital flows, EU funds are the main distinguishing feature between the EU Member States and other emerging markets since foreign direct investment is limited.
In the past it has been easier for CEE countries to broaden their market shares in the EU than to expand into new markets. This reads particularly true for younger EU Member States that have built up their export market shares within the EU to the detriment of the countries on the eurozone periphery, France and the UK. In 2015 the younger EU Member States could even overtake the peripheral countries in terms of market share in inner-EU exports thanks to their lower production costs, more flexible labour markets, geographical proximity and lower taxes. That said, CEE exports to the EU will barely grow by more than 5 percent in 2015.
The hopes of CEE countries are consequently placed on the USA and Germany. Even though UniCredit analysts predict stronger growth for the USA, this expansion will have a positive impact on CEE only to a limited extent and indirectly, via demand from Germany. In spite of a gradual acceleration in quarterly growth, German economic activity will likely slow this year to 1.2 percent after recording 1.5 percent in 2014. Next year this growth could pick up again to 2.0 percent.
Commercial sanctions against Russia could be lifted this year
Alongside elections in Greece and the uncertain growth prospects within the eurozone, international sanctions against Russia remain the key issue for CEE. Commercial sanctions could be lifted, if the 28 members of the European do not reach an agreement to extend them. If the commercial sanctions are partially revoked, Russia in return could ease the restrictions on food imports. By contrast, the financial sanctions will remain in place until the USA perceives a satisfactory solution to the Ukraine crisis.
"The impacts of the conflicts in Ukraine and the Middle East on CEE trade have been limited so far. Although the seasonal energy imports from Russia probably led to a widening of the CEE countries' trade deficit in the last quarter of 2014, we rule out any sharp deterioration in trade balances", states Bucsa. "The conflict in Ukraine poses a larger risk for Central and Eastern Europe through its impacts on the eurozone and Germany's economic outlook."
Russia, by contrast, is already facing a short-term risk of recession and lower potential growth in the future. This is due first and foremost to Russia's focus on commodity exports coupled with the declining energy intensity of the global economy, in which an increasing share of GDP is generated by the services sector, while the emerging markets are moving away from heavy industry towards higher value production. In the meantime, Russia cannot forego its energy exports to Europe, which are difficult to replace: for example, both of the latest supply contracts with China will reach roughly 60 percent of annual gas exports to Europe only in 2018.
Domestic demand – completed reforms as the distinguishing factor
If exports were to disappoint in 2015, the CEE markets will require robust domestic demand. Yet not every country has this cushion. It will be difficult for Ukraine, Serbia and Croatia to overcome the recession given their weak fundamentals and unresolved fiscal issues. In Russia, consumption and investment will not be able to compensate for the low commodity prices and the lack of external financing.
In the younger EU Member States the resilience of the growth will depend heavily on consumption and investment drivers which already had an effect in 2014: namely, low inflation, dynamic development of labour markets and accommodating monetary policies.
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