I. Recent Developments, Outlook, and Risks

International Monetary Fund. European Dept.
Published Date:
November 2015
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While a modest contraction in activity is expected this year for the Central, Eastern and Southeastern Europe (CESEE) as a whole, this reflects widely divergent country-specific developments. Most economies are growing at a relatively healthy pace, with the exception of Russia and the rest of the CIS, which are in recession. CESEE growth is expected to turn positive in 2016, but risks are tilted to the downside. Regional financial markets have, generally, weathered well the recent bouts of market volatility stemming from worries about Grexit, slowing activity in China, and falling commodity prices.

A. Recent Developments

In the first half of 2015, economic developments continued to differ widely across CESEE countries (Figure 1.1):

  • In Central and Eastern Europe (CEE) and Southeastern European EU members (SEE EU) the recovery, generally, proceeded at a solid pace. The main tailwinds were stronger domestic demand, lower oil prices, improved euro area growth prospects following the launch of the ECB’s quantitative easing (QE), and increased absorption of the EU Structural and Cohesion Funds (SCFs). Both CEE and SEE EU also benefited from improved competitiveness vis-à-vis the rest of the world, as their currencies weakened along with the euro.

  • Most SEE non-EU economies, except Serbia, also saw relatively strong growth. In contrast, Serbia is only gradually emerging from the recession caused by the devastating floods in 2014.

  • Growth in the Baltics has softened this year due to larger-than-expected spillovers from the recession in Russia and other CIS countries.

  • In Turkey, growth remained robust, in the face of downside risks to investor confidence stemming from political uncertainty and elevated corporate debt.

  • Russia and the rest of the CIS are in recession. The Russian economy contracted due to a combination of continued Western sanctions, low oil prices, and structural weaknesses. The recession deepened in Ukraine, reflecting declining activity in the eastern conflict zone and ongoing macroeconomic adjustment. Russia’s recession has had a negative effect on activity in other CIS countries through the trade and remittances channels and via confidence effects on consumption and investment.

Figure 1.1.CESEE: Quarterly GDP Growth

(Percent, year over year)

Sources: Haver Analytics; and IMF staff calculations Note: CESEE = Central, Eastern, and Southeastern Europe; CEE = Central and Eastern Europe; SEE = Southeastern Europe; CIS = Commonwealth of Independent States.

Domestic demand was generally robust outside the CIS, with investment growth supported by greater absorption of EU SCFs. Private consumption remained buoyant across CESEE EU countries and Turkey (Figure 1.2), on the back of lower oil prices and favorable employment and income dynamics. Investment surged in SEE EU countries and remained a major growth factor in CEE EU, driven by the sharp acceleration in the absorption of SCFs before the pending deadline for use of budgeted amounts for 2007–13 (Box 1.1). In contrast, consumption and investment in the CIS declined in response to worsening terms of trade, tighter credit conditions (Figure 1.3), and strong inflationary pressures (Figure 1.6).

Figure 1.2.CESEE: Contributions to Real GDP Growth

(Percent, year over year)

Sources: Haver Analytics; and IMF staff calculations Notes: CESEE = Central, Eastern, and Southeastern Europe; Semi-annual data constructed as the average of the respective quarterly data.

Figure 1.3.CESEE: Real Domestic Bank Credit to Private Sector

(12-month growth rates net of foreign exchange valuation effects and CPI-deflated, percent)

Source: EBRD, ECB, Haver Analytics, IMF International Financial Statistics, and IMF staff estimates.

Notes: CESEE = Central, Eastern, and Southeastern Europe; CEE = Central and Eastern Europe; SEE = Southeastern Europe; CIS = Commonwealth of Independent States; CPI = Consumer Price Index.

Figure 1.4.CESEE: Changes in Domestic Deposit-Loan Gaps and Private Savings-Investment Balances

(Percent of GDP)

Source: Eurostat, Central Bank of Russia, Orbis, and Fund staff calculations.

Note: Data are not consolidated within the corporate sector. Debt includes loans and securities. For Russia and Turkey, the ratios are calculated from firm-level data.

Figure 1.5.CESEE: Nonperforming Loan Ratios


Sources: IMF FSI database

Note: NPL ratio is the ratio of gross nonperforming loans to total loans. The data for 2015 are either as of 2015:Q2 or the latest available.

Figure 1.6.CESEE: Headline Inflation

(Percent, year over year)

Sources: Haver Analytics; IMF, national authorities; and IMF staff calculations.

Note: CESEE = Central, Eastern, and Southeastern Europe; CEE = Central and Eastern Europe; SEE = Southeastern Europe; CIS = Commonwealth of Independent States.

Box 1.1.CESEE: EU Structural and Cohesion Funds 1/

The European Union’s (EUs) Structural and Cohesion Funds (SCF) amount to about one-third of the total EU budget (192.6 billion euro over 2014–20). Their main objectives are to promote convergence, regional competitiveness and employment, and thus to improve the functioning of the internal EU market. All EU countries are beneficiaries, with lower income CESEE countries receiving proportionately bigger shares relative to their GDP. SCFs are not “free” for the recipients. In addition to the safeguards offered by the European Commission (EC) oversight, national authorities provide around 15 percent co-financing to ensure ownership, depending on the operational program. Certain costs, for instance most land purchases and value added taxes on inputs, have to be fully covered by national authorities, at times raising the effective co-financing to 40–50 percent. Moreover, operating costs, such as those for waste management projects, are fully borne by the beneficiary.

There are three SCFs: (1) the European Fund for Regional Development, which is tasked with modernizing economic structures (e.g., improve public administration), infrastructure (e.g., improve metro systems), and support R&D and innovation, environmental protection (e.g., solar and wind energy, waste water and sewage projects), etc.; (2) the European Social Fund, which focuses on increasing worker and enterprise adaptability and employment participation, and reinforcing social inclusion, among other areas; and (3) the Cohesion Fund, which supports regions with per capita gross national income of less than 90 percent of the EU average, in the transport, environment and energy sectors. The allocations from the first two funds are guided by the principle of additionality, under which only new projects can be financed.

Breakdown of 2007-13 Structural and Cohesion Funds by Types of Projects

(Shares in national allocations, percent)

Sources: European Commission and IMF staff estimates.

The funds are primarily spent on public and private investment, but also on goods and services. CESEE countries use a bigger share of the SCF allocations, relative to the average for the EU, for transportation infrastructure and environmental projects (see Figure above). Both CEE and SEE EU countries invest less in R&D than their EU peers.

SCF allocations are budgeted over 7-year “program periods” (e.g., 2007–13; 2014–20). Funds that are not drawn within the pertinent deadlines (i.e., two years (N+2) or three years (N+3) are, generally, lost for recipients. SCFs are administered by national authorities under close monitoring by the EC. Following the negotiation of country allocations, a “partnership agreement” is signed between the EC and member states for each program period. This is then followed by more detailed “operational programs” that include objectives and “priority axes”. National authorities choose the individual projects, with the EC monitoring all aspects of the process, including procurement procedures, IT systems, audit practices, etc. There is typically under-execution of SCF absorption in the beginning of each program period (figure below). Besides some advance payments at the start of each program period, reimbursements are made upon the presentation of invoices vetted and ultimately certified initially by the national certifying authority and then by the EC. If proper procedures are not followed, “irregularities”, such as administrative oversights, violations of public procurement regulations, or outright fraud, may be identified. In cases of serious irregularities, the reimbursement of EU Funds can be suspended. Confirmed irregularities also trigger an adjustment in EU co-financing, ranging from a haircut to a full charge back to governments. The EU grants, however, may not always be fully lost, since they can be reallocated to other projects, if the national authority has “over-booked” the pertinent program.

Czech Republic, Bulgaria and Slovak Republic have sharply increased the absorption (ratio of EC pay-outs relative to budget allocation) of 2007–13 funds in the run-up to the pending deadline for their use. In the case of Romania and Hungary, EC payouts were not as strong in the first half of the year. In Hungary, this was due to the suspension of some operational programs, with the burden of payment temporarily shifted to the national budget. In Romania, there is a discrepancy in the timing of recording of disbursements between the EC data and fiscal accounts, as the former are on a cash basis and the latter are on a commitment basis. Fiscal data point to an increase in absorption in the first half of 2015. For all countries, the absorption in the second half of the year is expected to be even stronger, as countries strive to reach certified payout rates of 95 percent. On the other hand, Lithuania and Estonia have already absorbed most of the available funds from the 2007–13 program period.

CESEE: Payouts from EU Structural and Cohesion Funds under 2007–13 Program

(Percent of recipient country’s GDP)

Source: European Commission and IMF staff estimates. Note: 2015 data is until June and are divided by half of projected 2015 GDP.

CESEE: EU SCF Allocations

(Percent of GDP in first year of program)

Source: European Commission and IMF staff estimates.

The hastened absorption could, however, adversely affect growth and fiscal positions:

  • Rushed projects may be more prone to irregularities, which may result in larger fiscal burden in 2015–16.

  • If they were to materialize, recently floated ideas about retroactively providing EU funding for projects that originally had been fully domestically financed would create risks for use of the newly created fiscal space for unproductive current spending.

  • Since efforts have been focused on the previous seven-year program period, preparations for the new period (2014–20) have been delayed in some countries. This may cause a slump in absorption of SCFs in 2016, adversely affecting growth.

  • Priority may have been given to shovel-ready projects (e.g., amelioration of urban public spaces) rather than to ones that could better enhance potential output.

  • The 2014-20 budget envelope is 10 percent larger than the 2007-13 one in nominal terms, but significantly smaller in percentage of the recipient’s GDPs (figure). Therefore, the impact of SCFs on growth will likely progressively decline, unless more efficient use of the funds will compensate for their smaller relative size.

These potential downsides are likely to be less of an issue in the Baltics, which have demonstrated better preparedness to absorb SCFs in a more timely manner.

1/ This box was prepared by Plamen Iossifov and Tonny Lybek.

Crisis legacies—private sector debt overhangs and high nonperforming loans (NPLs)—continue to weigh on economic activity and credit growth in parts of the region. While many countries have made significant adjustment – as reflected in a notable improvement in the private sector net saving-investment balances and a decline of banking systems’ loan-to-deposit ratios – the balance-sheet repair is not yet fully completed (Figure 1.4). The Spring 2015 REI (IMF, 2015b) highlights the persistent debt overhang in several SEE and CIS economies (notably, in Bulgaria, Croatia, and Ukraine). Data for 2015:Q1 show that non-financial corporations’ debt-to-equity ratios in Croatia, Latvia, Bulgaria, Romania, and Slovenia are still well above the euro area average. Reflecting weaknesses in private balance sheets and slow pace of distressed debt resolution, the aggregate NPL ratios remain persistently high, exceeding 10 percent in many SEE and CIS countries (Figure 1.5).

Inflation trends remain divergent between CEE/SEE and CIS/Turkey. The prolonged disinflation across Europe reversed course in 2015:Q1, but the reflation has since stalled, as oil prices fell again (Figure 1.6). In contrast, inflation has remained high or accelerated further in Turkey and CIS countries, on the back of expansionary policies (Turkey) and capital outflow pressures that weakened domestic currencies.

Inflation expectations in SEE and CEE EU countries have stabilized at historically low levels (Figure 1.7). The recent fall in inflation expectations in SEE and CEE EU countries—for which comparable data are available—cannot be fully explained by their normal response to falling oil prices (see Box 1 in IMF (2015b) for details). Thus far, this overshooting does not appear to have impacted real activity, but renewed disinflationary pressure would raise concerns of possible unanchoring of inflation expectations.

Figure 1.7.CEE and SEE EU: Inflation Expectations

Sources: European Commission and Consensus Economics Forecasts.

Notes: Euro peggers – Bulgaria and Croatia; Inflation targeters - Czech Republic, Hungary, Poland, and Romania; It is generally believed that firms form their expectations using professional forecasters’ projections, whereas households tend to follow the general sentiment reflected in survey results. Consumer inflationary expectations index reflects survey responses to the question on price trends over next 12 months. It is calculated as + 1* (“Pecentage thinking it will rise a lot”)+ 1/2 * (“Pecentage thinking it will rise moderately”- 1/2 * (“Pecentage thinking it will stay about the same”) - 1 * (“Pecentage thinking it will fall”).

CESEE financial markets have weathered well the bouts of market volatility stemming from worries about Grexit, slowing activity in China, and falling commodity prices. Across the three periods discussed below, CESEE have generally performed better than other EM regions:

  • The ECB’s QE boost: since the start of the year, equity and bond markets rallied across much of the region, mirroring developments in the euro area (Figures 1.8). While the ECB’s QE raised investor confidence, net financial flows into CESEE markets were negative in 2015:H1 (Figure 1.9). In the case of EU member states, however, these outflows were more than offset by the inflows of EU funds through the capital account (Figure 1.9).

  • Grexit worries and an increase in German bund yields: The re-emergence of market worries about Grexit in May and a correction in German bond yields had little impact on regional financial markets, including SEE countries with sizable trade or financial links with Greece (Figures 1.8). The subsidiaries of Greek banks operating in the SEE countries experienced some deposit outflows, which remained in the domestic banking system (see below).

  • Concerns about China slowdown and commodities sell-off: During July-September 2015, equity markets across the region posted modest losses, while sovereign spreads widened by less than 50 basis points in most countries (except Turkey), and only some currencies (Turkey, Russia and other CIS countries) saw depreciation pressures (Figure 1.8). The spike in global risk aversion (VIX) in the last week of August triggered the largest outflows from mutual funds investing in CESEE since the May 2013 “taper tantrum” (Figures 1.8 and 1.10). The outflows were largest from bond funds.

Figure 1.8.Oil price and Financial Market Developments

Source: Bloomberg. Note: CESEE = Central, Eastern, and Southeastern Europe.

1 Euro bond spread. Exchange rates are vis-à-vis USD.

Figure 1.9.CESEE: Net Capital and Financial Account Flows

(Billions of US dollars)

Sources: Haver Analytics and IMF staff calculations.

Notes: CEE = Central and Eastern Europe; SEE = Southeastern Europe; Capital account, which mostly comprises of EU Structural and Cohesion Funds, is shown only in the first panel.

What explains the resilience of the CESEE financial markets? One reason is that trade links of the CESEE region with China are relatively small (Box 1.2). In addition, the impact of China’s rebalancing on commodity prices is a positive terms-of-trade shock for most CESEE countries, in contrast with emerging market commodity exporters (such as Brazil, Indonesia, and Russia). At the same time, most CEE and SEE countries are in a different phase of the credit cycles compared with other emerging markets. Many CEE and SEE countries have made notable progress in private sector deleveraging—via improvements in the private saving-investment balances—that has reduced their external vulnerabilities (Figure 1.11). This makes them more resilient to changes in international investor sentiment. That said, these countries are not immune to a more persistent rise in global risk aversion, which could result in sustained capital outflows, with a greater impact on countries with a larger share of foreign investors in their local markets (such as Poland and Hungary).

Figure 1.10.Flows into Foreign Exchange-Traded and Mutual Funds Investing in Emerging Europe

(Million U.S. dollars)

Source: Haver Analytics, EPFR.

Figure 1.11.CESEE: Post-Crisis Private Sector Adjustment


Source: WEO, IFS

Box 1.2.CESEE: Implications of a Slowdown in China and Major Emerging Markets 1/

The direct trade links between CESEE and China are small. The share of domestic value added from the region consumed by China is less than 2 percent of CESEE countries’ GDP (see Figure). Russia and those CESEE economies that are more integrated into the global supply chains (the Czech and Slovak Republics, and Hungary) are most exposed. This suggests that—in the absence of any impact of China’s slowdown on investor confidence and risk premiums—the impact on CESEE would be small.

Figure. CESEE: Domestic Value-Added Embodied in Chinese Final Demand, 2011

(Percent of GDP of exporting country)

Source: OECD-WTO Trade in Value Added (TIVA) dataset.

Model simulations of the transmission of China’s growth slowdown to CESEE via the real channel—through both direct and indirect channels—confirm that the impact is fairly small. The IMF’s Flexible System of Global Models (FSGM) used for this exercise is a multi-region, forward-looking, semi-structural model (Andrle, M., et. al., 2015). In the model, lower growth in China affects world growth through two channels. First, lower than expected investment and growth in China implies weaker exports for the rest of the world. Second, it implies weaker global demand for commodities and lower commodity prices (including oil and metals). The simulation assumes a weakening of Chinese growth by around 1.5 percentage points on average over the next five years (relative to the October 2015 WEO baseline), combined with yuan depreciation vis-à-vis the dollar by 10 percent and an increase in the Chinese risk premium by 100 basis points. All countries with policy space are assumed to use it to offset the shock. Model simulations show that the impact on CESEE countries would be relatively small (see Figure below). This is, importantly, due to the assumption that these countries have fiscal and in most cases monetary space to engage in countercyclical policies that counteract the impact of the shock.

Spillovers from a broader economic slowdown in emerging economies would be bigger, but manageable. The October 2015 WEO (Scenario Box 1) presents a scenario that assumes a slower pace of catching-up and lower productivity growth, combined with a tightening of external financing conditions in large emerging economies (including in Russia and Turkey). Commodity prices fall and emerging market currencies depreciate in response to the growth slowdown and reversal of capital flows. The key results are as follows:

  • The impact on smaller emerging economies in CESEE is double that under China-only slowdown, but is short-lived and small relative to the size of the assumed negative shock on large emerging markets.

  • The substantially lower growth in Russia and Turkey compared to baseline under this scenario mostly reflects the assumed slowdown of their own potential growth, rather than spillover effect from China and other emerging economies. The spillovers

  • to Russia and Turkey from a structural slowdown in the other emerging markets is of similar magnitude to that in non-euro area EU countries.

Figure. CESEE: Simulations of Impact of China and EMs Growth Slowdown

(Real GDP growth rates, percent)

Source: IMF’s Research Department Flexible System of Global Models.

Notes: Baseline real GDP growth rates are from the October 2015 WEO; WEO EMs slowdown scenario—assumes slower pace of catching-up and lower productivity growth, combined with a tightening of external financing conditions in large emerging economies (including in Russia and Turkey); Spillovers from other EMs slowdown scenario—same as the WEO EMs slowdown scenario, except that there is no structural slowdown in Russia and Turkey and CESEE countries do not benefit from flight-to-safety capital inflows from other emerging markets.

1/ This box was prepared by Plamen Iossifov, Susanna Mursula, Agustin Roitman, and Jiae Yoo.

Some banks in SEE countries saw deposit outflows during the Greek crisis in late June/early July 2015. Greek-owned subsidiaries and branches have a significant presence in five SEE countries—Albania, Bulgaria, FYR Macedonia, Romania, and Serbia—holding 12-22 percent of total banking sector assets (see IMF (2015b) for details). In the immediate aftermath of the Greek referendum, some subsidiaries of Greek banks experienced deposits outflows, although those outflows were channeled to the rest of the domestic banking system. Prudential measures and enhanced monitoring that have been in place for some time, along with other actions by national central banks have helped enhance confidence and have proven effective in dampening the initial contagion. The situation has since stabilized but authorities should remain vigilant.

B. Outlook

The 2015 GDP growth forecast for CESEE remains broadly unchanged since the May 2015 REI, but there are notable shifts in contributions of countries. Growth was revised up in CEE and SEE, kept unchanged in Russia and Turkey, and revised down in the Baltics and other CIS countries (Figure 1.12).

Figure 1.12.CESEE: Growth Forecasts and Revisions since May 2015


Source: IMF country teams’ estimates.

Note: CEE = Central and Eastern EuropeEurope; EU = European Union; SEE = South- Eastern Europe; CIS = Commonwealth of Independent States; 1/ Domestic policies represent financial conditions and fiscal policy (including EU funds); 2/ Geopolitical and domestic political uncertainty and consumer confidence.

The revisions to 2015 GDP growth reflect both domestic and external factors (Figure 1.12):

  • External demand: The ECB’s QE, launched in March 2015, has supported economic activity in the euro area with positive effects on CEE. At the same time, the recessions in Russia and Ukraine had negative spillovers on the CIS and the Baltic countries.

  • Oil prices: Oil prices returned to multi-year lows over the summer, extending their support of real disposable incomes in most CESEE, while dragging down growth in oil exporters (Russia).

  • Fiscal policy: In Belarus, Bosnia and Herzegovina, and Kosovo, fiscal tightening is expected to weigh on growth. Delays in public investment projects will contribute to lower growth in Montenegro. In contrast, greater-than-expected absorption of EU funds by the EU countries outside the Baltics, will provide a boost to growth.

  • Domestic monetary and credit conditions: Tighter credit conditions turned out to be more of a drag on growth in the CIS than previously expected, while monetary policy easing in Russia has counteracted the negative terms-of-trade shock.

  • Other country-specific factors: The conflict in Eastern Ukraine has taken a larger-than-expected toll on growth of the Ukrainian economy. On the other hand, growth in EU SEE and CEE has benefited from improved domestic demand, supported by gains in consumer confidence and wage growth.

Inflation projections for 2015 have been revised down across CESEE since the Spring 2015 REI. The main disinflationary drivers have been the renewed weakness in oil prices (with higher transmission to consumer prices in the Baltics) and lower food prices in Russia and some SEE non-EU countries (Figure 1.13). Factors that contributed positively to inflation include the depreciation of domestic currencies in Turkey and CIS, excluding Russia, and the faster-than-anticipated closing of output gaps in CEE and SEE EU. Some country-specific factors, such as the sharp tightening of monetary policy in Belarus (which adopted monetary aggregate targeting) and the cut in the value-added tax on food in Romania, had a sizable downward impact on inflation in these countries. In Turkey, both inflation and inflation expectations remain elevated.

Figure 1.13.CESEE: Inflation Forecast and Revisions since May 2015


Source: IMF country teams’ estimates.

Note: CEE = Central and Eastern Europe; EU = European Union; SEE = South-Eastern South-Eeastern Europe; CIS = Commonwealth of Independent States; 1/ Domestic policies include output gap and changes in taxes.

In 2016, growth in many CESEE countries is expected to continue at a pace broadly similar to that in 2015, except in CIS and the Baltics (Figure 1.12 and Annex I). As the Russian economy stabilizes and contraction of activity slows and Ukraine’s economy rebounds, neighboring economies will be seeing higher growth rates in 2016. By contrast, the anticipated normalization of the annual absorption rate of EU SCFs will likely slow growth in CEE (Box 1.1). The expected sustained growth in SEE EU countries is predicated on a successful rotation of investment expenditures from the absorption of EU funds into private investment. In the SEE non-EU countries, the IMF program with Serbia is forecast to help support a somewhat stronger rebound from the 2014 recession.

Inflation trends will continue to be bimodal in 2016 (Figure 1.13 and Annex II). The weakness of emerging market currencies amidst the ongoing rotation of financial sector risks from developed to emerging markets will keep inflation elevated in the CIS and Turkey, albeit on a downward trajectory. The significant downward revision in World Economic Outlook (WEO) medium-term projections of commodity prices are driving markdowns to inflation forecasts in the rest of CESEE, though inflation is generally expected to move closer to central bank inflation targets. The inertia in inflation expectations is contributing to the slow pace of change in inflation outcomes.

C. Risks

The balance of risks to CESEE growth has shifted from broadly neutral at the time of the Spring 2015 REI to being tilted to the downside. New risks to trade and capital flows stemming from a possible further slowdown in major emerging markets (notably, in China) as well as the ongoing refugee crisis in Europe are the main additions to long-standing risks. Table 1 highlights the key external downside risks and the IMF staff’s assessment of the relative likelihood and impact of these risks on the region. They include:

  • Weaker-than-anticipated external demand:

    • From China: While direct trade links between CESEE and China are relatively small, commodity exporters (Russia) and the most open CESEE economies (Czech Republic, Slovak Republic, and Hungary) would be most affected by a decline in the import demand from China through both direct and indirect channels (Box 1.2).

    • From Russia: CESEE countries with close links to Russia/CIS—notably, other CIS countries and the Baltic states—would be negatively affected if the recession in Russia deepens further1.

    • From the euro area: Weaker-than-expected euro area growth would take a toll on the CEE and SEE EU, which are most closely integrated into pan-European global value chains. The potential negative fallout from the Volkswagen emissions scandal could be damaging for the Czech and Slovak economies, and to a lesser extent, for Hungary and Poland.

  • A surge in financial market volatility and a tightening in global financial conditions: Given their high dependence on foreign funding and generally compressed risk premiums (Box 1.3), CESEE countries are vulnerable to tightening of external financing conditions that could be triggered by dislocations in advanced or emerging markets:

    • Contagion from renewed selling pressures and volatility in emerging markets (including China), on account of weaker emerging market fundamentals could result in capital outflows and liquidity strains on CESEE sovereigns and leveraged firms.

    • A return of financial stress in the euro area (e.g., on concerns about the Greek program) remains a risk, particularly for weaker subsidiaries of Greek banks in SEE, as well as other CESEE sovereigns and financial institutions that are reliant on funding from the euro area.

    • A faster-than-expected tightening in the U.S. monetary policy or a persistent U.S. dollar appreciation could trigger a reassessment of emerging market prospects. A stronger U.S. dollar and higher dollar borrowing costs may lead to balance sheet strains in countries with significant dollar-denominated debt, such as Russia, Turkey, Hungary and Ukraine.

  • Intensification of geopolitical tensions (around Russia/Ukraine and the Middle-East) could prolong recessions in CIS countries and dampen investor sentiment in other countries (e.g., the Baltics, Turkey). The ongoing refugee crisis in Europe (Box 1.4) could put pressure on public finances, disrupt trade flows—as countries struggle to secure their borders—and cause political tensions and divisions within the European Union.

Table 1.CESEE: Regional Risk Assessment Matrix
Source of RisksLikelihoodImpact
Lower-than-expected growth in advanced economies/the euro areaHighMedium
Further growth deceleration/decline in major EMs (BRICs)HighMedium
Surge in financial volatility/a tightening in financial conditionsHighMedium
Intensification of geopolitical tensions/refugee crisis in EuropeMediumMedium-High
Source: IMF staff assessment.Notes: The relative likelihood of risks reflects the IMF staff’s subjective assessment of the risks surrounding the baseline. The relative impact is based on country-specific assessments weighted by purchasing-power-parity GDP. “Low” indicates a probability below 10 percent, “Medium” indicates a probability of 10 to 30 percent, and “High” indicates a probability of 30 to 50 percent.

There are also a number of country-specific risks. In several countries in the region, there are increased pressures for populist fiscal loosening and worsening the composition of budgets that may increase vulnerabilities and be viewed negatively by investors. Another risk is an un-anchoring of inflation expectations, due to persistently low oil prices and weak inflation expectations.

On the upside, lower oil prices and policies aimed at supporting domestic demand may boost activity more than currently anticipated. For example, policy measures to unclog financial intermediation could boost CESEE domestic demand and a stepped-up ECB QE could further improve euro area growth prospects as well as CEE and SEE competitiveness.

Box 1.3.CESEE: Vulnerability to External Financial Shocks 1/

Countries with sizable external financing needs or elevated sovereign credit spreads are more vulnerable to external financial shocks (see Figure). As discussed in the Spring 2014 REI, the level of rollover risk depends critically on the composition of external borrowing. For some countries (most notably the Baltic states) the rollover risks are mitigated by the fact that a sizable portion of payments falling due is related to the inter-company loans, which have proven to be as stable as FDI. On the other hand, countries that have a relatively large share of maturing debt denominated in USD (Turkey, Russia) are more vulnerable to the USD appreciation and to the U.S. interest rate hikes. In the case of Hungary, the FX conversion of mortgages (finalized in February 2015) will be accompanied by a reduction in short-term external debt, and less reliance on net FX swaps—significantly lowering roll-over needs from 2016 onwards (see Figure).

CESEE: External Vulnerabilities

(Percent of GDP)

Source: WEO, EBRD, and Fund staff calculations.

CESEE: Gap Between Actual and Fitted Sovereign CDS Spreads

(August, 2015, Basis points)

Market risk premiums are generally compressed, increasing the risk of abrupt correction. Based on IMF staff’s estimates, the CDS spreads for most CESEE countries are lower than their model-based medium-term norms (see Figure)2/. The CDS spreads of Hungary, Croatia, and Slovenia appear to be particularly compressed, making these countries relatively more vulnerable to a sharp decompression of risk premiums, when global financial conditions tighten. For Turkey, the higher-than-model-based estimate of the CDS spread is likely a consequence of increased political uncertainty.

More leveraged firms and households are more vulnerable to the negative funding shocks. The latest 2015:Q1 data shows that the non-financial corporations’ debt-to-equity ratios in Bulgaria, Croatia, Latvia, Romania, and Slovenia remain elevated.

Countries with higher share of foreign investors in local markets tend to be more vulnerable to contagion. For example, the share of foreign holdings of local currency government debt securities is particularly high (over 30 percent of the total) in Hungary and Poland.

1/ This box was prepared by Yan Sun and Plamen Iossifov.2/ The fundamentals-consistent values of CDS spreads are derived from Heinz and Sun (2014) regression model that links them to market’s consensus forecasts for the current and the following year of the real GDP growth, government budget deficit, current account balance, public debt to GDP ratio, as well as the depth of the CDS market (proxied by the CDS bid-ask spreads), and global investment sentiment (proxied by VIX).

Box 1.4.Making Sense of Different Attitudes toward Migration among EU Countries1/

The recent surge in migrant2/flows to Europe has put in the spotlight the long-standing issue of migration. Governments have taken different approaches to the current humanitarian crisis, with some balking at the costs imposed on EU frontier countries by the Dublin regulation—under which requests of asylum seekers from outside the EU should be processed in the country where they first enter—while others suspending the regulation’s provisions in order to legally accept migrants. What accounts for these differences in attitudes?

Europe: Net Migration and Initial Income Levels

Sources: Eurostat, World Bank World Development Indicators, and IMF staff calculations.

Europe: Share of Foreign-Born Persons in Total Population, 2014


Source: Eurostat.

Note: Foreign-born refers to people born in other countries, including EU members.

International experience offers evidence on both the short-term costs and potential long-run benefits of migration. An upcoming IMF Staff Discussion Note argues that the net fiscal impact of migration is, initially, likely to be negative, reflecting the cost of humanitarian aid and integration policies. Over time, however, the fiscal burden diminishes, as migrants gradually enter the labor force and contribute to tax revenues. The impact on employment and wages of native workers is generally found to be small and short-lived. In the long-run, the expansion of the labor force should boost the potential output of host countries. Fully leveraging on the human capital potential of migrants depends crucially on countries’ ability to successfully integrate migrants.

Different countries’ focus on short-term costs or long-term benefits can be seen as reflecting differences in institutional capacities, income levels, and other factors. Migration flows are driven, to a large degree, by differences in income levels and strength of social safety nets between sender and receiver countries. Most CESEE countries with per capita incomes below USD 15,000 (PPP-adjusted) have been on the sender side of migration flows since the late 1980s (see Figure above). Inward migration to wealthier CESEE countries has been mostly from other CESEE countries. Overall, the share of foreign-born persons living in Central, Eastern, and Southeastern Europe (CESEE) is much lower than in Western Europe (see Figure below). CESEE countries, therefore, generally lack the institutional setup and knowhow to integrate large numbers of migrants from outside Europe. This also reflects CESEE region’s more limited historic links with countries outside Europe.

1/ This box was prepared by Gil Mehrez and Plamen Iossifov (with input from Krzysztof Krogulski).2/ The term migrant refers to “all people on the move who have yet to complete the legal process of claiming asylum” (

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