Euro area recession dragging exports down...
Growth dynamics in the export markets is an important factor governing the CESEE countries’ export performance: it explains over half of the cross-country variations observed. For example, the recession in the euro area has obviously had more of a dampening effect on the new member states (NMS) in Central Europe, where more than 50% (in the Czech Republic over 60%) of their exports go to the euro area, rather than on countries such as Ukraine, Turkey and the Baltic states, whose trade dependence on the euro area is considerably lower.
Furthermore, divergent growth performance within the euro area has also mattered. In the NMS in Central Europe that trade mostly with Germany, export growth has remained in low single digits, whereas in most Western Balkan countries that trade more with crisis-torn Greece and Italy, it has turned negative, with declines of up to 15% in Montenegro and Kosovo.
At the same time, tourism in Croatia and Montenegro, which in both countries is at least as important as industry, has continued to thrive, more than compensating for the shortfalls in the export of goods.
By way of contrast, Latvia and Lithuania, which trade more with Russia, recorded double-digit export growth, as did energy-exporting Russia and Kazakhstan.
However, the relatively high export growth in euro terms recorded by the latter two countries should not be over-interpreted, as it reflects to a large extent the weakening of the euro against the US dollar.
In dollar terms (the currency in which energy exports are typically invoiced), export growth in both countries was much lower.
... and industrial production as well
By and large, the dynamics of industrial production in the CESEE countries has mirrored their export performance (see Figure 2). Interestingly, the cross-country differences to be observed in the geographic pattern of exports have a visible impact on the performance of individual industries and, in some cases, individual producers – at least when it comes to more sophisticated industrial branches such as the manufacture of transport equipment.
For instance, the production of Renault cars in Slovenia that are sold in EU markets has declined, whereas the Dacia factory in Romania (also owned by Renault) was able to maintain production levels and even increase exports, mainly to countries in the Southern Mediterranean. A similar picture is to be observed in Slovakia. Whereas both Volkswagen and KIA have recorded high sales growth primarily on account of their exports to the more buoyant markets in the United States, China and Russia, the performance of PSA Peugeot-Citroen, which is also producing in Slovakia and only supplies EU markets, has been more modest. Overall, however, motor car production in Slovakia surged by an astonishing 44%; it was the key driver behind an impressive 10% growth in total industrial output. In Kazakhstan, the growth of motor car production was of similar magnitude, but starting from a much lower base. In essence, it represented a substitution of Chinese imports after Kazakhstan joined the Russia-led Customs Union and increased the duty on imported motor cars accordingly.
The geographic orientation of exports matters less where basic industries such as energy and metals are concerned, the output of which is more homogeneous and whose prices are largely shaped by global developments. Given the high (albeit stagnating) oil prices hovering around USD 100 per barrel, the previous year’s modest growth in industrial production in energy-producing Russia and Kazakhstan may come as a surprise; it was primarily due to supply bottlenecks.
In the metals industry, which is particularly important in the Western Balkans and Ukraine, the price decline already mentioned has had a differentiated impact on individual countries, suggesting the prevalence of country-specific factors. In Serbia and Montenegro, for instance, US Steel and Russia’s Rusal effectively shut down their mills in 2012, yet production in the US Steel mill in Slovakia supplying inputs to the country’s booming car industry has been kept going. In Ukraine, the metals industry is ever-increasingly suffering from largely out-dated technologies and the high energy-intensity of production; it has thus become a drag on the country’s growth prospects.
Economic growth too low to ease the labour markets
The anaemic economic performance (let alone recession) to be observed in most CESEE countries is not helping to lower the rate of unemployment, which leapt in the wake of the crisis in 2009 and, in most instances, has continued to rise slowly but steadily ever since. Nearly everywhere in the region, economic growth lies far below the benchmark of around 3%, the minimum generally required to sustain employment levels. GDP growth slower than that can be attained by simple labour productivity improvements such as the adoption of new technologies or better management and marketing, without entailing the need to hire additional labour. Further progress in economic restructuring – at least in the more advanced NMS countries – yields diminishing returns in the form of lower labour productivity increases, thus probably bringing the requisite GDP growth ‘threshold’ closer to levels observed in the ‘old’ EU (1.5-2%). However, under the circumstances currently prevailing in most CESEE countries, even that level of growth looks unattainable. To top it all, the fiscal austerity regime pursued in some NMS countries and the Western Balkans has led to lay-offs in the public sector – notably in Croatia, where they contributed to the dramatic 5% drop in employment in 2012.
The cross-country variation observed in growth performance has been generally too small to explain the differences in the employment dynamics1 and has been offset by other factors. For instance, in all three Baltic countries, employment expanded appreciably (by 2-3%) and unemployment rates declined accordingly. However, this can be only partly attributed to these countries’ relatively high GDP growth: another important factor is the fact that this growth has to a large extent been accounted for by the labour-intensive services sector. This effect has been even more pronounced in Montenegro where expansion of the labour-intensive tourism sector has resulted in 2% growth in employment – despite a decline in overall GDP. Slovakia offers an example to the contrary. Its GDP growth in 2012 – though reasonably high – was driven primarily by an upturn in the manufacture of motor cars, which is relatively less labour-intensive. As a result, Slovakia’s employment expanded only marginally in 2012 and only partly absorbed the increase in the labour force attributable to return migration, as result of which the unemployment rate even increased.
The population and labour force dynamics are having a more general effect on labour markets in the CESEE countries. Wherever the labour force is shrinking owing to demographic factors and/or net outward migration, even stagnating employment levels can be consistent with declining unemployment. By the same token, it can be safely assumed that the unemployment rates would have been (even) higher, had there been no shrinkage in the labour force. In that respect, the results of the most recent population censuses conducted in most CESEE countries in the course of 2011 may offer valuable insights.
To a large extent, the discrepancies reflect the high (and previously under-estimated) outward migration from those countries over the past decade. Their citizens have been entitled to EU-wide visa-free travel and (in the case of Latvians and Lithuanians) work in most EU countries for a number of years – not taking into account the sizeable volume of ‘shadow’ employment. Although no recent census has been conducted in Ukraine, anecdotal evidence suggests that outward migration from that country over the past decade has also been substantial, with Russia featuring as a prime destination.
Migrants leaving a country in search of jobs elsewhere are improving the labour market situation in their country of origin, while the related inflows of remittances are often an important source of (mostly consumption and housing) finance, with a significant impact on domestic spending. However, the implications are far-reaching not only for the labour markets of the countries involved. For instance, the new census figures imply that given the smaller populations, the per capita GDP levels of Romania, Bulgaria, Latvia, Lithuania, Croatia and Albania are 2-12% higher and their development gap with respect to the ‘old’ EU countries, for example, is accordingly narrower than previously assumed.
To date, the protracted euro area crisis has not led to a substantial wave of return migration to the CESEE countries, although – as mentioned above – Slovakia may offer an example to the contrary. In fact, outward migration from some CESEE countries to the ‘old’ EU may even accelerate somewhat in the years to come. This applies primarily to Bulgaria and Romania, where living standards are generally much lower than in Slovakia, for example.
Citizens of both countries will be granted unrestricted access to the entire EU labour market with effect from January 2014 at the latest.2 This also holds potentially true for Croatia, which will join the EU in July 2013 and whose citizens will acquire the right to work at least in certain EU countries immediately upon accession.
Outward migration from those countries will probably help to ease conditions in the respective labour markets. This would appear particularly important in the case of Croatia with an unemployment rate approaching 16%. In other Western Balkan countries, however, where the labour market situation is even worse and cross-border labour mobility is restricted by the sheer fact that they are not (and will not be anytime soon) in the EU, unemployment is likely to stay stubbornly high, with potentially grave consequences for the social cohesion and political stability of those countries.
Flat incomes, fiscal austerity and deleveraging suppress private consumption
Deteriorating labour market conditions are suppressing the dynamics of wages and household incomes in general (see Figure 3). Even in those CESEE countries where unemployment has recently declined (such as the Baltic states), the decline started out from a high level and has apparently not been pronounced enough to provide a major boost to wages – at least in real terms. Only in the CIS countries did wages pick up markedly in 2012 – by up to 14% in Ukraine. It has to be borne in mind, however, that wage-setting in the CIS countries is typically more flexible than in the NMS countries, for example: their trade unions are (even) weaker and a larger proportion of wages is less formalized, i.e. paid unofficially. On that account, wages rather than employment absorbed the bulk of the shock during the 2009 crisis in the CIS countries, potentially pointing to a still existing ‘catch-up’ potential.
The cross-country differences to be observed in the wage dynamics can also be attributed in part to differences in the fiscal stance. In Ukraine and to a lesser extent Bulgaria, pre-election hikes in public sector wages and social spending fuelled the growth of wages and household incomes. Reverse developments were to be observed in a number of NMS and Balkan countries (for example, in Slovenia and the Czech Republic) where wage cuts in the public sector were important features of the budget consolidation programmes.
Another factor obviously affecting real wages and incomes has been the dynamics of consumer price inflation. By and large, inflationary pressures in the CESEE region remained fairly weak in an environment characterized by under-utilized capacities and relatively stable energy prices and exchange rates. However, in a number of instances, the performance of agriculture has played a crucial role – particularly in the poorer CESEE countries with a high share of food items in the consumer basket. For instance, the relatively abundant harvests exerted downward pressure on consumer prices in Turkey and Ukraine, and to a lesser extent in Russia. In Serbia, on the contrary, the dismal harvest was a major factor that prevented a drop in inflation, thus largely offsetting the pre-election wage hikes.
In the NMS countries, the dynamics of consumer price inflation has been primarily driven by fiscal policy moves. In Latvia, the real incomes of households were strengthened by lowering the VAT rate in a move to suppress inflation and so conform to the levels set in the Maastricht criteria for the adoption of the euro. Elsewhere, policy has shifted largely in the opposite direction. For instance, in the Czech Republic, Hungary and Poland, the fiscal austerity programmes involved hikes in indirect taxation and/or administrative fees that eroded the real purchasing power of households.
High unemployment and stagnant wages, coupled with prevailing uncertainties and the ongoing, albeit in some cases visibly decelerating, deleveraging of the household sector, continue to weigh heavily on the dynamics of private consumption in most CESEE countries (see Figure 4). In this respect, Turkey presents a special case. The stagnation of household consumption in 2012 was the result of the Turkish government’s deliberate efforts to ‘cool down’ an overheated economy by putting the brakes on credit expansion. Elsewhere in the region, the problem is rather the reverse. The authorities would probably be glad to see more buoyant household demand, but they often lack the appropriate tools (and in some cases political will) for such an undertaking.
Once again, the exceptions are to be found primarily on the ‘fringes’ of the region. In the Baltic states and CIS countries, private consumption has enjoyed a revival on the back of receding unemployment and recovering wages, respectively. Furthermore, in both Russia and Kazakhstan, where the banking sector is largely domestically owned and the overall mood is better, consumer lending has been on the rise. In Kazakhstan and Ukraine, however, the current pace of private consumption growth will hardly be sustained. For very different reasons, both countries are likely to re-balance and re-direct their growth paths – in the medium term at the latest – towards investments and net exports, respectively.
Crucial role of public investments
The modest recovery of fixed capital investments in the CESEE countries following the crisis in 2009, if it was observed at all, was a generally short-lived affair (see Figure 5). Those developments are also mirrored in the persistent weakness of the construction sector that has recently shown clear signs of deterioration in a number of instances. In most NMS countries in Central Europe as well as in Croatia, investment and construction have been contracting ever since the crisis in 2009, while in 2012 the volume of construction also fell markedly in Albania and Ukraine – and more moderately in Poland.
The dismal performance of the construction sector (and investments more generally) across the region is only partly a legacy of the recent ‘bursts’ of real estate bubbles. In the Baltic states, Bulgaria, Ukraine, and most recently in Slovenia as well, the bursting bubbles have indeed left lasting scars on the banking sector. The soaring non-performing loans have certainly contributed to a ‘credit crunch’ in those countries (inordinately high interest rates and stringent lending conditions), as has the ongoing external de-leveraging of the banking sector, with the European banks reducing their exposure in large segments of the CESEE region. However, in the NMS countries in Central Europe, such as the Czech Republic, Slovakia, Hungary and Poland, which have not suffered real estate crises of the same magnitude, the dynamics of construction and investments has been equally – if not more – disappointing. As exemplified by the Czech Republic, even very low interest rates have been unable to trigger more buoyant investment demand. Overall, the role of high interest rates should not be over-estimated, given that large parts of the business sector are awash with liquidity and are typically financing investments from profits – if at all – rather than by taking out loans. More generally, investment activity is suppressed by the lasting, and in some cases deteriorating, perception of uncertain future prospects and underutilized capacities in an environment characterized by weak demand, while country-specific factors also play a role. In Russia, investments, particularly into the non-oil sector, continue to be deterred by weak institutions, widespread corruption and insecure property rights, whereas in Turkey they have been recently curtailed by strict monetary constrictions aimed at ‘cooling down’ the economy.
Under these circumstances, the dynamics of fixed capital investments in the region have been increasingly shaped by public investment projects. In Estonia and Romania, the double-digit investment growth in the previous year was primarily due to large-scale transport and energy infrastructure projects, partly financed by EU transfers. In Turkey, government-sponsored projects partially offset the decline in private investments, while in Ukraine investments in the first half of 2012 were driven by infrastructure projects ahead of the European football championships and came to a standstill once those projects were finished. In 2012 Latvia was the only CESEE-country where the revival in construction and investment activities stemmed primarily from the private sector. However, with large-scale infrastructure projects in transport and energy on the government agenda, public investments will play an increasing role over the next few years also in Latvia. A pick-up in infrastructure investment in the course of the current year is also projected for Lithuania, Poland, Croatia and Serbia: in the latter two cases, financed by EU transfers and foreign credits, respectively.
Conversely, the budget consolidation programmes currently underway in most other CESEE countries fall heavily on investments. Furthermore, while EU transfers within the framework of the EU Structural and Cohesion Funds continue to be an important source of investment finance in many NMS countries, they typically require co-financing from national budgets – funding that is not always forthcoming. For this and other reasons (such as the insufficient expertise in raising this type of finance), the absorption rates of EU transfers in the NMS countries are typically low – generally much lower than in the ‘old’ EU member states. The pursuit of budget austerity is suppressing investments not only directly, but in some cases indirectly as well – to the extent that public and private investments complement each other (‘crowding-in’). Slovakia appears to be a case in point: the lack of a motorway connecting the more prosperous western part of the country with the more backward eastern part continues to be a drag on private investments in the latter region – notwithstanding the country’s otherwise strong investment credentials.
Net exports drive GDP growth – despite the weak external environment
In 2012, weak exports and suppressed domestic demand (partly due to fiscal austerity) pushed nearly half of the CESEE region into recession, including the Czech Republic, Hungary, Slovenia and all the Western Balkan countries, with the exception of Albania. Elsewhere, growth remained positive; however, it was generally unspectacular, with the notable exceptions of Kazakhstan and Latvia, where growth exceeded 5%. In countries that hitherto had been relatively immune to the crisis, growth dynamics also progressively decelerated in the second half of the year. In Russia and Poland, a ‘soft landing’ has come increasingly to the fore, while the ‘touchdown’ has been more abrupt in Turkey, Romania and particularly in Ukraine, whose economy slipped into recession as its metals exports collapsed. In the heavily agricultural countries, Romania and Serbia, poor harvests have also played a role, pushing food prices upwards and eroding the purchasing power of households.
On the whole, 2012 was a disappointing year for the CESEE economies, confirming fears of a double-dip recession in large parts of the region. This rather poor performance stands in sharp contrast to the better dynamics in other ‘emerging markets’ in Asia and Latin America. It also underscores the dependence of large parts of the CESEE region on the troubled euro area (not least in terms of policies pursued) and the structural weakness of some of its economies, such as Russia and Ukraine.
There is little doubt that both external and domestic factors are to be blamed for the CESEE countries’ disappointing growth performance. Still, Figure 6 showing demand components for 2012 suggests that the crucial factor was the weakness of domestic demand. In the majority of CESEE countries (including nearly all the NMS countries, except Estonia and Bulgaria), net exports contributed positively to GDP growth – despite the anaemic external environment. This reflects the fact that generally speaking import demand has been lagging behind export growth. These developments have also been broadly mirrored in the nominal dynamics of exports and imports, with current account deficits declining and surpluses increasing. The most impressive turnaround has been in Slovakia. The country’s current account switched from a 2% deficit to a 2% surplus, and Slovakia joined Hungary and Slovenia as yet another external surplus country among the NMS countries. From the point of view of external vulnerability, this is obviously a welcome development. However, in some CESEE countries where concerns over external sustainability matter most, the situation has hardly improved – with the important exception of Turkey. Ukraine is a case in point: here, net exports have been a huge drag on GDP growth, and the already high current account deficit widened still further, calling in question the wisdom – and indeed the sustainability – of the country’s policy of maintaining an exchange rate peg to the US dollar.
Outlook: ‘muddling through’ in the near term, gradual improvements thereafter
NMS prospects hinge on recovery in the euro area
The protracted recession in the euro area which will likely continue in 2013 will be a drag on the economic growth of the NMS countries – with the notable exception of the Baltic countries that trade relatively more with Russia. By and large, the NMS countries are small open economies held hostage to the excessive fiscal austerity pursued in the ‘northern’ euro area countries and the sluggish progress on the part of the euro area policy-makers in addressing the structural roots of the crisis (such as large internal imbalances and insufficient fiscal integration). At the same time, in the NMS countries private sector demand is unlikely to recover substantially given the high (and rising) unemployment, stagnant wages and credits, and persistent overall uncertainties. In those instances when investments increase, the increase will be primarily funded via public money, with EU transfers playing an important role. On a positive note, in Poland and the Czech Republic, the disappointing growth performance is likely to prompt the authorities to pursue fiscal austerity less rigorously, with less contractionary effects on the real economy.
In general, the NMS countries’ prospects for 2013 are unimpressive and, on average, only marginally better than the previous year – largely on account of the expected negligible improvement in domestic demand (see Figure 7). While an expected moderate fiscal relaxation in the Czech Republic may bring GDP growth back into positive territory, in Poland it will at best offset a decline in private investments, resulting in rather unimpressive GDP growth of less than 2%. Elsewhere, the scope for a less restrictive fiscal stance will be constrained by other policy priorities: efforts to obtain release from the excessive deficit procedure set by the EU (viz. Hungary, Slovakia and Romania, in the latter case complemented by the potential need to comply with IMF requirements) and regain credibility in the eyes of financial markets (in Slovenia). At the same time, in Hungary, real incomes will be strengthened by the recent reduction in household energy tariffs and possibly other pre-election ‘carrots’, while in Romania agriculture is expected to recover after the dismal performance of the previous year. These factors may have moderately positive repercussions on economic dynamics in both countries, so that Hungary will probably avoid another recession this year and growth in Romania will accelerate slightly. On the other hand, Slovakia’s export-led growth is likely to lose steam, as the extraordinarily high growth in motor car production and exports observed in the previous year is unlikely to be repeated. The abrupt decline in the car production in December 2012 may be a worrying signal in this respect. Slovenia will not be able to avoid another recession this year as it struggles to overcome the legacy of a recently ‘burst’ real estate bubble, reflected in a virulent banking crisis.
Overall, only in 2014 will a more deeply rooted economic recovery in the NMS countries finally start in line with the recovery projected for the euro area. The export-oriented industrial sector of the NMS is fundamentally strong and should take full advantage of the eventual euro area recovery next year and thereafter.
A new growth strategy?
Even under the most optimistic scenario, in the medium and long term the CESEE countries will be generally unable to replicate the growth rates observed prior to the 2008-2009 crisis. The relative scarcity of previous sources of growth, such as foreign capital (including foreign direct investment), under the present circumstances is raising the issue of an alternative growth model for the region, both within academic circles and among policy-makers. The latter could involve, for instance, a more active role being accorded to so-called ‘industrial policy’, including targeted support for the tradable sector. This issue is of particular relevance, for example, to countries such as Russia and Kazakhstan, where production and export diversification away from the low value-added and inherently volatile energy sector is both desirable and feasible – provided the political will and appropriate institutions are in place and wise use is made of the substantial financial resources that both countries have accumulated in their sovereign wealth funds. The scope for industrial policy is arguably less in the Western Balkan countries and Ukraine, which generally lack both the financial resources and appropriate institutions to support such a policy. They will probably have little choice but to rely primarily on foreign investment in order to upgrade their ailing industrial sector.
In the NMS countries, where industrial restructuring over the past decades has been more successful and will likely continue to bear fruit in the future as well, the major economic policy challenge arguably lies elsewhere: the task of identifying a way to re-direct their long-term economic growth more towards domestic demand. Strengthening domestic demand in those countries would most probably require increasing their (currently rather low) wage shares and upgrading their welfare systems. That, however, is diametrically opposed to the aims and objectives of the fiscal austerity programmes currently underway in most NMS countries.
Read the full report in pdf document attached.